Fordham Law Review
Volume 39 | Issue 4
Article 1
1971
Real Estate Equity Investments and the Institutional
Lender: Nothing Ventured, Nothing Gained
Frank E. Roegge
Gerard J. Talbot
Robert M. Zinman
Recommended Citation
Frank E. Roegge, Gerard J. Talbot, and Robert M. Zinman, Real Estate Equity Investments and the Institutional Lender: Nothing Ventured,
Nothing Gained, 39 Fordham L. Rev. 579 (1971).
Available at: http://ir.lawnet.fordham.edu/flr/vol39/iss4/1
This Article is brought to you for free and open access by FLASH: The Fordham Law Archive of Scholarship and History. It has been accepted for
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REAL ESTATE EQUITY INVESTMENTS AND THE
INSTITUTIONAL LENDER: NOTHING VENTURED,
NOTHING GAINED
FRANK E. ROEGGE, GERARD J. TALBOT, AND ROBERT 2f. ZINMAN*
I.
THE INSTITUTIONAL LENDER AS A REAL ESTATE ENTREPRENEUR
IN recent years there has been much talk about the activity of institutional investors in what are loosely called "joint ventures" in real estate.
These investments may include single buildings or large developments
located throughout the country. While in the past institutional investors
traditionally restricted their real estate investments to fixed return mortgages and sale leasebacks, with changing economic conditions their philosophy also changed, resulting in the joint venture phenomenon. Some of
the problems accompanying this change are the subject of this article.
A. "Revolution" in Institutional Thinking
The most important institutional lenders making long term mortgage
loans traditionally have been life insurance companies, savings and loan
associations, mutual savings banks, and banks as trustees for pension
trusts 1 Commercial banks, which formerly were primarily interested in
construction lending, have recently stepped up their long term mortgage
lending, while insurance companies have also become active in the construction-lending field.2
Life insurance companies constitute the largest element in long term
commercial mortgage lending,3 with broad investment powers (though subject to regulation), and may be considered typical institutional investors.
Their development as real estate entrepreneurs may represent the greatest
change in attitude and approach to real estate investment by institutional
lenders. In three states which are generally considered prominent in the
area of life insurance-Massachusetts, New York and New Jersey-first
mortgage loans became a permitted form of investment in 1818,4 1848,5
* Members of the New York Bar. The authors gratefully acknowledge the advice and
assistance of their associates, and particularly the assistance of Theodore F. Feldman of the
New York Bar.
1. See Bureau of the Census, U.S. Dep't of Commerce, Statistical Abstract of the
United States 449 (1970).
2. Id.
3. See Board of Governors of the Federal Reserve System, Flow of Funds Accounts
1945-1968, Annual Total Flows & Year-End Assets and Liabilities 77 (1970); Board of
Governors of the Federal Reserve System, Flow of Funds, Seasonably Adjusted 4th Quarter
16 (Prelim. 1970).
4. See Law of Feb. 16, 1818, ch. 120, § 3, [18181 Mlass. Laws 527 (repealed 1860).
5. See Law of April 8, 1848, ch. 205, § 1, [18481 N.Y. Laws 71st Sess. 319 (repealed
1892).
FORDHAM LAW REVIEW
[Vol. 39
and 1852,6 respectively. Somewhat later, investment (or perhaps it should7
be termed speculation) in real estate with or without statutory authority,
became popular. In 1870, one of the most prominent New York insurance
companies invested eighty percent of its assets in its home office building. 8
In 1905, the Armstrong Committee, considering abuses by life insurance
companies, reported:
[T]he testimony taken by the committee discloses flagrant abuses in connection with
investments in real estate. Under the guise of procuring suitable accommodation for
the transaction of business excessive amounts have been expended in the acquisition
of land and buildings not necessary in any proper sense for the uses of the corporation, which yield a poor return upon the amount expended. . . .No further purchase
of property should be permitted under subdivisions 1 and 2 of section 20 of the Insurance Law or under section 14 of the General Corporation Law without the consent
of the Superintendent of Insurance upon his finding that the acquisition is necessary.
Section 13 of the General Corporation Law, providing that the Supreme Court might
authorize purchases of real property in lieu of similar property disposed of, should
0
be rendered inapplicable to insurance corporations.
This report led directly to the passage of section 100 of the New York
Insurance Law of 1909,10 which was the precursor of the present provision of section 81(7). This section required that the Superintendent of
Insurance approve any real estate acquisition other than through foreclosure or other satisfaction of debt. Under the terms of the statute, even
ownership of foreclosed properties was expected to be terminated within
6. See Law of March 10, 1852, ch. 74, § 10, [1852] N.J. Laws 153 (repealed 1903).
7. At the time, the only statutory authority for the acquisition of real estate by New
York life insurance companies was contained in Law of June 24, 1853, ch. 463, § 9, [18531
N.Y. Laws 76th Sess. 890 (repealed 1892), which prohibited an insurance company from
purchasing, holding or conveying real estate, except:
"1. Such as shau be requisite for its immediate accommodation in the transaction of
business; or
"2. Such as shall have been mortgaged to it in good faith, by way of security for loans
previously contracted... ; or,
"3. Such as shall have been conveyed to it in satisfaction of debts previously contracted
in the course of its dealings; or,
"4. Such as shall have been purchased at sales upon judgments, decrees or mortgages
obtained or made for such debts . . . . [AIll such real estate as may be acquired as aforesaid, and which shall not be necessary for the accommodation of such company in the
convenient transaction of its business, shall be sold and disposed of within five years after
" See also text accompanying
such company shall have acquired title to the same ....
note 9 infra.
8. For an entertaining discussion of how this came to be, see The New Yorker, Oct. 21,
1961, at 139, 144-45.
9. 7 Report on Hearings of N.Y. State Joint Legislative Investigating Committee 290-91
(1905) (emphasis added).
10. Law of Feb. 17, 1909, ch. 33, § 100, [1909] N.Y. Laws 132d Sess. 16, published
as ch. 28, art. 2, § 100 [1909] Consol. Laws of N.Y. 1843 (repealed 1939).
1971]
REAL ESTATE EQUITY INVESTMENTS
five years,1 and extensions from the Insurance Department were not
automatically granted.' In 1922, the Insurance Law was amended to
permit the acquisition of certain housing without the Superintendent's
approval."3
In 1946, the New York Insurance Law was changed by adding paragraph (h) to section 81(7),4 to permit investment in real estate for the
production of income. The law also permitted improvement or develop-
ment pursuant to an existing program to make the property incomeproducing. Significantly, properties acquired by foreclosure or deed in
lieu thereof and held under subsection 7(c) could be transferred to paragraph (h), and no longer had to be disposed of within five years from
the date of acquisition.
About the same time, other states-most notably New Jersey"8 in
1945, and Massachusetts' 0 in 1947-were adopting similar legislation.
Finally, in 1963 the new Michigan constitution and resulting legislation
authorized acquisition of real estate for investment,'1 and in 1967, Texas
permitted limited ownership.' 8 Consequently, ownership by life insurers
of real estate for investment is permitted, in some form, in every state.
11. Id. § 20, published as ch. 28, art. 1, § 20 [1909) Consol. Laws of N.Y. 1782 (repealed 1939).
12. "Such certificate can be obtained by filing in this Department an affidavit by an
officer of the company setting forth the fact that diligent efforts to dispose of the property
has [sic] been made but without success and that the interest of the company wil suffer
from a sale at this time.' Ruling of New York Insurance Department, Dec. 26, 1912, in
2 G. Dorn, Annotated Insurance Law of New York 320 (1934). Mi1lss Dora, who was an
attorney with the Insurance Department for many years, compiled her own notes and
various other material into two unpublished volumes, which can be found in the library of
the College of Insurance in New York, New York.
13. Law of April 13, 1922, ch. 658, § 1, [1922] N.Y. Laws 14Sth Sess. 1802 (repealed
1939). Similar language is now contained in N.Y. Ins. Law § 81(7)(h) (McKinney Supp.
1970).
14. Law of April 5, 1946, ch. 509, § 1, [1946] N.Y. Laws 169th Sess. 1139, as amended,
N.Y. Ins. Law § 81(7) (h) (McKinney Supp. 1970).
15. Law of April 24, 1945, ch. 226, § 1, [1945] N.J. Laws 169th Sess. 736.
16. Law of April 17, 1947, ch. 269, § 1, [1947] Mass. Acts & Resolves 250, adding
Mass. Gen. Laws ch. 175, § 66B (1947).
17. The Michigan Constitution of 1963 omitted most of Article XII of the earlier
constitution of 1908, section 5 of which had imposed restrictions on corporations in holding
real estate. See also Law of Aug. 19, 1969, ch. 318, § 1, [1969] Mich. Pub. Acts 670,
amending Mich. Stat. Ann. § 24.1947 (Supp. 1970).
18. Law of June 17, 1967, ch. 660, § 1, [1967] Texas Gen. Laws 60th Sems. 1753, adding
Tem. Ins. Code Ann. art. 3.40-1 (1963). Some restrictions, however, are imposed. For example, the purchase of undeveloped real estate for the purpose of development or subdivision
is prohibited. Moreover, a substantial portion of the property must be materially enhanced
in value by the construction of durable, permanent-type building and other improvements.
FORDHAM LAW REVIEW
[Vol. 39
From time to time various state statutes have been liberalized as to
amount and other limitations. 19
While the legislative history of subsection 7(h) in New York shows
an intent to permit insurance company investors to acquire and profit
from equity acquisitions, 0 most acquisitions under this subsection were
"sale-leasebacks," under which the institution purchased real estate and
leased it back to the tenant for a fixed net rent, often with the privilege
of renewing at a lower rent. Presumably this renewal at a lower rent
reflected the fact that the insurer, through fixed net rent during the
initial term, would recover its initial investment plus a return approximately equal to or slightly above the prevailing rate of interest on first
mortgages. The slightly higher rate of return reflected the fact that the
purchase price of the property acquired in the sale-leaseback arrangement usually would exceed the limitations of two-thirds or three-fourths
of the value of the real property which investment statutes frequently
imposed upon mortgage lending,2' and that rent recovery, unlike foreclosure deficiency judgments, was limited to one year's rent in the event
of the tenant's bankruptcy, and three year's rent in the event of reorganization.22 Despite the higher rate of return, the result of these early
equity acquisitions with a fixed return, coupled with frequently inserted
19. See, e.g., Law of April 18, 1957, ch. 646, § 1, [1957) N.Y. Laws 180th Sess. 1430,
amending N.Y. Ins. Law § 81(7)(h) (McKinney 1949). The 1957 amendment Increased
the total amounts that life insurers could invest in real estate from three to five percent,
and increased from $250 million to $500 million the amount that could be invested in each
parcel. Id. See also Law of July 5, 1961, ch. 1080, § 1, (1961] Cal. Stat. 2811, amending
Cal. Ins. Code § 1194.8 (West 1955); Law of July 3, 1968, ch. 380, § 1, [1967J Del. Laws
1302 (now Del. Code Ann. tit. 18, § 1325 (Spec. Insurance Pamphlet 1968)); Law of
July 20, 1967, § 1, [1967] Ill. Laws 75th Sess. 1816, amending Ill. Ann. Stat. ch. 73,
§ 125.19a (Smith-Hurd 1937).
20. "On account of the continued downward trend of interest rates and the consequent
dearth of suitable investments which qualify under Section 81, the life insurance companies
particularly find it difficult to invest their funds to yield an income sufficient to meet the
interest rates assumed in their outstanding contractual obligations. It is expected that the
broadening of the classes of reserve investments as proposed will relieve the present investment situation to some extent." Memorandum from Robert E. Dineen, Superintendent
of Insurance, to the Governor, March 26, 1946, in Bill Jacket to Law of April 5, 1946, ch.
509 [1946] N.Y. Laws 169th Sess. 1139. The "Bill Jackets" or "Governor's Bill Jackets"
contain letters, studies, legal memoranda, and other material-either sent originally to the
Governor or submitted to him by his counsel or the committee chairman-urging him to
sign or veto a bill. The original jackets are located in the Legislative Reference Library in
Albany and, except for a few earlier jackets, generally cover the period from 1921 forward.
The collection has now been microfilmed and may be seen at the New York Public Library
(42d Street branch) in New York City.
See also the approval of the Committee on State Legislation of the Association of the
Bar of the City of New York, and other writings contained in the Bill Jacket.
21. See note 35 infra.
22. 11 U.S.C. §§ 103, 602 (1964).
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REAL ESTATE EQUITY INVESTMENTS
limited repurchase options or rejectable offer provisions,m was to give the
insurer little more economically than it had in conventional mortgage
investing.
However, some insurers still had various buildings acquired through
foreclosure, and in some cases such properties, after transfer to paragraph (h), were managed by managing agents and became highly profitable. Through efficient operation, higher rents, and perhaps modernization,
these properties produced yields far in excess of those obtainable through
mortgage lending. In some cases, subsequent sales of such properties also
produced substantial capital gains. These properties-and also office
building properties built and partially occupied by insurers, who leased
to other tenants-proved that equity ownership could be highly profitable to institutional investors.
The number of foreclosed properties suitable for retention was strictly
limited, however, and insurance companies were not always the best
planners, developers, builders and promoters. Those normally engaged in
these activities could be hired for a fee, but perhaps could not be expected
to work with the same zest shown in developing properties in which
they had a financial interest. In the late forties, the fifties and the early
sixties, builders and developers did not view insurance companies as
fellow equity participants in the many buildings they were constructing.
Hopefully, the insurance company mortgage or purchase price in a saleleaseback would cover all costs. If not, private sources of funds-generally from high tax bracket individuals investing as limited partnerswould fill the gap. This situation prevailed well into the sixties.
Beginning about 1966, however, external factors produced a revolution
in real estate development. The most significant of the factors were inflation, high interest rates, tight money, and falling common stock prices.
1. Inflation
While life insurers classically paid claims in fixed dollars, factors such
as expenses and dividends caused them to seek protection against infla23. In many sale-leasebacks, the vendor-tenant has the right to repurchase the property
from the institutional landlord under a repurchase option or rejectable offer provision contained in the lease. Under a rejectable offer provision-which is often found in sale-leasebacks involving chain operations such as gas stations and supermarkets where, for business
reasons, the tenant may wish to terminate its operations-the tenant could offer to purchase
the land at a price determined by a formula in a lease, and the landlord could accept or
reject this offer. If the landlord rejected the offer, the tenant would have the option of
terminating the lease. Of course, all the repurchase options and rejectable offer provisions
must be so worded and contain such limitations as to prevent the transaction from being
considered a mortgage. See Hill, Usury-New Statutes, Cases and Problems, 20 Ass'n Life
Ins. Counsel Proceedings 739, 749 (1968). With respect to personal property, see Uniform
Commercial Code § 1-201(37).
FORDHAM LAW REVIEW
(Vol. 39
tion not offered by fixed return mortgage loans or sale-leasebacks. Contingent interest or percentage rent were answers, but not total ones.
Contingent interest, which is additional interest often based on the income of the property, faced limitations imposed by usury statutes, and
by its very nature yielded nothing after maturity of the loan. Percentage
rent, which is additional rent also based on such income, offered better
possibilities. Many developers, however, did not wish to engage in a saleleaseback, which involved a sale of the building and loss of income tax
benefits.24 Similarly, institutional investors did not wish to buy only the
land, since they would receive no tax benefits from ownership of a nondepreciable asset.2 5
2. High Interest Rates
While in the late sixties interest rates increased to their greatest heights
since the Civil War,2 6 some state usury statutes were not amended at
the same speed at which national interest rates were increasing. Thus,
in many jurisdictions mortgage loans, with or without contingent interest,
ceased to constitute attractive investments for institutions.2 On the
other hand, where usury laws permitted above average rates, fixed rate
mortgage loans generally were non-prepayable for many years and thus
constituted a serious burden on developers.
3. Tight Money
The "credit crunch" of 1966 and the general credit situation in 19691970 helped produce the so-called "revolution" in institutional thinking.
Insurers obtained less money from mortgage prepayments and paid more
out in policy loans,2 8 and banks and savings and loan associations were
subject to a lack of growth in assets or actual disintermediation. 2' Consequently, they limited the number of mortgage loans made and carefully
scrutinized each mortgage,"0 unwilling to lend as freely as in the past.
24. Of primary concern is depreciation. Int Rev. Code of 1954, § 167.
25. Id.
26. One economist has been quoted as saying that interest rates are "higher than at
any point since the Napoleonic Wars." Wall Street J., March 15, 1971, at 1, col. 6. But see
1971 Information Please Almanac, Atlas and Yearbook 156 (1970). See also U.S. Dep't of
Commerce, Historical Statistics of the United States, Colonial Times to 1957, at 654 (1960).
27. See Fortune, July, 1970, at 93.
28. Policy loans in 1960 amounted to $5,231,000,000, or 4.4 percent of assets. The
comparable figure in 1969 was $13,825,000,000, or 7.0 percent of assets. Institute of Lifo
Insurance, Life Insurance Fact Book 90 (1970) [hereinafter cited as Life Insurance Fact
Book].
29. See United States Savings and Loan League, Savings and Loan Fact Book 11-12
(1969).
30. See Fortune, supra note 27, at 92.
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REAL ESTATE EQUITY INVESTMENTS
Even where financing was available, the gap between the loan amount
and the amount of money needed by the builder increased.
4. Falling Common Stock Prices
As this gap increased, the availability of funds from secondary sources
(often wealthy individuals seeking tax shelters) was affected by a decline in common stock prices. With the Dow Jones industrial average
falling from 989.12 on December 16, 19681 to 627.46 on May 26, 1970,32
many prospective investors could no longer borrow on their stock and,
in any case, were not interested in acquiring additional tax losses.
The situation was ripe for change, and change came. Financial institutions, first slowly and perhaps nervously and then in ever greater volume,
acquired true equity interests in office buildings, office parks, apartment
house developments, industrial parks and other income-producing real
estate."3 Some took their equity interests as bonuses for making loans 4
However, unless the loan exceeded the permitted percentage of value,3 5
either by too generous an appraisal or through the use of a "basket!' or
"leeway" statute,3 6 this did not solve the basic problem which led to the
"crevolution," i.e., the builder's shortage of funds. Even with an oversized
loan, and without considering the problem of usury,37 his fixed charges
would probably be too high. Therefore, more insurers entering the field
bought an equity interest at a fair price based upon the value not when
the project would be an established success, but reflecting the possibilities, the risks, and the potential at the time of agreement-usually before
construction commenced. The equity interest acquired was usually substantial-typically fifty percent.
Some insurance companies apparently went further, giving up mortgage lending and investing their real estate funds only in equity interests.
They, of course, obtained the highest leverage. Such investments, how31. N.Y. Times, Dec. 22, 1968, § 3 (Bus. & Fin.), at 2, col. 6.
32. Id., May 31, 1970, § 3 (Bus. & Fin.), at 2, col 7.
33.
Life Insurance Fact Book, supra note 28, at 89.
34. See Fortune, supra note 27, at 93.
35. In New York, as in other states, the mortgage loan usually cannot exceed twothirds, or in certain cases three-fourths, of appraised value. N.Y. Ins. Law § 81(6) (a)
'(McKinney 1966), as amended, (McKinney Supp. 1970). Under some circumstances, however, mortgages are allowed even with loan-value ratios in excess of three-fourths. See note
36 infra.
36. In New York, the "basket" statute is found in section 81 of the Insurance Law.
N.Y. Ins. Law § 81(17) (McKinney Supp. 1970). It allows insurance companies, inter alia,
to make loans with loan-value ratios as high as 100 percent, provided all such loans and
other investments made under the leeway provision do not, in the aggregate, exceed
3Y2 percent of the company's admitted assets.
37.
See part III C infra.
FORDHAM LAW REVIEW
[Vol. 39
ever, were possible only where someone else would make the mortgage
loan without an equity investment. Opportunities of this nature were
limited, since many institutions were not enthusiastic about making
mortgage loans to give leverage to a competitor. Thus developers, at
least in very large transactions, tended to seek large life insurers as both
mortgage lenders and purchasers of equity interests, and the large life
insurers sought large developments where they could invest not only in
a mortgage loan, but also in a substantial interest in the equity.
B. Effect of the "Revolution"
The partial shift of institutional funds from fixed return mortgage
loans to equity investments did not constitute the entire "revolution."
Changes resulting from this shift also comprised a large part of it.
As many life insurers began to acquire common stocks, 8 institutional
investment philosophy also changed. Safety properly remained essential,
but the emphasis on what constituted safety shifted.3 9 The servant who
buried his talent had kept it safe, but he was rebuked by his master.40 A
life insurance loan officer investing throughout 1969 and 1970 in seven
percent fixed return mortgage loans would not be praised. While safety
lay in part in avoiding or reducing the effect of inflation, it became recognized that for large institutional investors safety should be measured
by the whole, not as to each part. For instance, one loan officer might
invest $100,000,000 in seven percent "ultra safe" ten year mortgage loans
which, ignoring repayment and reinvestment of interest and amortization,
would result in $170,000,000 in assets in ten years. On the other hand,
another loan officer might put $90,000,000 of his $100,000,000 in slightly
less safe eight percent ten year mortgages, and $10,000,000 in related
equity interests of far greater risk. Assume that one $5,000,000 mortgage
goes into default and shows no return above principal, and that the
$10,0000,000 equity interests show returns varying from partial loss of
principal to a return of forty percent, but an overall return of twenty
percent per annum for the ten year period. Again ignoring repayment and
reinvestment of interest and amortization, his $90,000,000 will have
grown to $158,000,000 and his $10,000,000 to $30,000,000 for a total of
$188,000,000. He may have had to think harder, negotiate harder, and
worry more, but who is to call his performance "less safe" or call him
the less deserving servant?
Furthermore, insurers as equity investors obtained a better understand38. Investments in common stocks increased from $403,000,000 in 1960 to $3,703,000,000
in 1969. Life Insurance Fact Book, supra note 28, at 74.
39. See Fortune, supra note 27, at 90-92.
40. St. Matthew 25:25-26.
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REAL ESTATE EQUITY INVESTMENTS
ing of the developer's problems and his philosophy. One of his needs is
speed, and this need alone has accelerated the change toward more prompt
decisions and servicing which already was underway in many insurance
companies. Coupled with the shift to common stock investments, this
has effected a change in the attitude of some insurance company investment officers. Together with the development of new products such as
real estate investment trusts, variable annuities and separate accounts,
it has led to a new image for insurance companies. Insurers will probably
never be the same
If the insurer has changed, so has the developer. Traditionally somewhat of a rugged individualist who took the institutional investor's money
but tried to hold the institution at arm's length, the developer dealt with
limited partners who either knew and trusted him or else were unsophisticated in the area. In any event, they were not bothersome to him. The
huge institution, however, had different approaches and different philosophies. Its officers wanted to know how much architects and contractors
were being paid, and perhaps share in the writing of architectural and
construction contracts. They were expense conscious, organization conscious, and conflict conscious. They were interested in the status of the
developer's key subordinates. They imposed limits on, or wanted to know
the reasons for, transactions with related corporations or persons. All
this was perhaps initially galling to him, but he learned that he had a
partner with far more to contribute than mere money. It had a wealth of
experience in real estate matters, acquired through many decades of good
and bad times. It also made available staffs of accounting, architectural,
economic and legal experts, and knowledge of the entire country, its
customs, possibilities, and economic data. The developer has profited
through such relationships, and he, too, will never be the same.
Society has benefited and changed from this increased efficiency. As
developers established relationships with large institutions, giving them a
steadier source of equity funds, greater stability and counter cyclical
influences emerged. 1
Perhaps most important, as the large life insurance companies began
to invest in real estate equities and common stock, holders of life insurance policies and annuities could effortlessly benefit from balanced investment programs designed to produce safety and yield, while reducing the
effect of inflation. This was previously possible only for the rich, who had
diversified investment capabilities.
Today some of the external factors that produced the so-called revolu41. When the money market is "tight?' and other sources of financing dry up, the
institutional investor can often provide both the funds necessary to maintain existing
projects and those required for new projects, thus retarding an economic reversal.
FORDHAM LAW REVIEW
[Vol. 39
tion in real estate development are no longer present. Interest rates are
beginning to decline; money is less tight; and common stock prices are
rising. Nevertheless, real estate equity investments by institutional lenders
have continued. Inflation is still with us; institutional thinking appears to
have changed irrevocably; and developers, having learned to live with
and having been benefited by institutional lenders as equity partners,
continue to seek institutional funds for joint ventures in real estate.
C. The Investment
Investments by institutions in real estate equities vary in form from
investor to investor, from developer to developer, and even from transaction to transaction between the same institution and developer. Nevertheless, real estate equity and associated mortgage investments often adhere
to a basic structure.
The institution may commit itself to make a mortgage loan to the
developer. The commitment is normally for a long term mortgage loan
(i.e., financing after the completion of the improvements), but may
also include a land loan (to acquire the real estate), a development
loan (to prepare the real estate for construction), and a construction loan
(for construction of the improvements). In the past, banks have been the
traditional source of construction financing, and other institutions have
tended to avoid becoming involved with the inherent problems of such
undertakings. Nevertheless, in connection with equity investments, even
insurance companies have, with increasing frequency, made construction
loans or participated in construction loans with banks or other traditional
construction lenders. Often the institution, when it does not have the
facilities or personnel to effectively protect its interest during the period
of development and construction, will not become involved in the equity
end of the transaction until completion of the construction. In such situations, development and land loans are often employed during construction
in lieu of the equity participation.4"
At the time of the long term mortgage loan commitment or commitments, or sometime thereafter, the institution or a subsidiary corporation
42. The developer will often need the amount of the equity contribution prior to
the completion of construction. To meet this need, the institutional investor may nake
a short term land loan in the amount of the prospective equity contribution, secured by a
mortgage on the real property. When the developer has complied with the conditions of
the equity commitment and the institution or its subsidiary becomes obligated to make the
equity contribution, that contribution is used to satisfy the land loan. If the institution or
its subsidiary does not take its equity interest until completion of construction, the developer
will be getting 100 percent of the tax deductions during the construction period. The value
of this additional tax benefit to the developer can be calculated, and offset with interest
charged on the land loan.
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REAL ESTATE EQUITY INVESTMENTS
may commit itself to purchase an interest in the property, subject to mortgages, either immediately or upon substantial completion of construction.
This equity interest is normally in the form of an interest in a partnership
owning the real estate under a written partnership agreement, or an interest
as a tenant in common in the real estate, together with an operating
agreement which may or may not constitute the parties partners.
Sometimes the transaction is far more complicated and involves the
use of numerous real estate investment techniques. In one such case, the
institutional lender purchased the real estate from the developers and
leased the property back to the developers (a traditional sale-leaseback) 4
The institutional lender then made substantial loans to the tenant, secured
by a mortgage on the leasehold estate (a traditional leasehold mortgage) ,"
and then a subsidiary of the institutional investor purchased an interest
in the leasehold subject to the mortgage (which may become, in a few
years, a "traditional" equity investment).
It should be made clear, however, that the equity interest described
above and discussed in this article is not what is sometimes referred to
as a "kicker" for a mortgage loan, or as a "piece of the action.""' These
words are anathema to many institutional investors. The interest being
discussed is an interest in property purchased primarily as an inflation
hedge, at a price based on the estimated future value of the interest fixed
by appraisal at the time of commitment, and with which comes the
attendant risk of loss and possibility of long term gain normally associated
with real estate development.
II.
THE VEHICLE
A. The "Joint Venture"
Normally the institutional investor and the developer will own and
operate the property through a general or limited partnership, 47 but in
common parlance most of the real estate equity investments in which
43. See part IV A infra_
44. See Practising Law Institute, Sale and Leaseback Financing (Real Estate Transcript
Series No. 6 (1969)); Gunning & Roegge, Contemporary Real Estate Financing Techniques:
A Dialogue on Vanishing Simplicity, 3 Real Prop. Probate & Trust J. 325, 341 (1963).
45. See generally Hyde, The Real Estate Lease as a Credit Instrument, 20 Bus. Law.
359 (1965); Mark, Leasehold Mortgages--Some Practical Considerations, 14 Bus. Law.
609 (1959); Riordan & Duffy, Lease Financing: A Discussion of Security and Other Considerations from the Institutional Lenders! Point of View, 24 Bus. Law. 763 (1969);
Thomas, The Mortgaging of Long-Term Leases (pts. 1-3), 150 N.Y.L.J, Aug. 19-21, 1963,
at 4, col. 2.
46. See Weaver, Real Estate-A "Piece of the Action" For Life Insurers, 71 Best's
Review, Dec., 1970, at 20 (Life/Health Ins. ed.).
47. See part If B infra.
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institutional investors have become involved are referred to as "joint
ventures." 48 Articles, 49 and at least one book,"' have been written with
titles such as "Joint Ventures in Real Estate," even though what is discussed therein is a partnership. The term is often used as a verb, as well
as a noun, and businessmen will speak of "joint venturing" a particular
piece of real estate. Many investment partnerships, the agreements for
which provide that they are governed by the particular jurisdiction's
Uniform Partnership Act (UPA), use the term "joint venture" or "venture"
in their names. In this article, the authors have for convenience often
referred to the partnership or other arrangement for the operation of the
property as a "joint venture." What is a joint venture? What is the effect
of using that term in connection with the agreement between the institution and developer? Does using the term create any special legal relationship between the parties, or affect the rights of third parties?
1. The Meaning of "Joint Venture"
Joint ventures are American in origin and are unknown in English
law." At first they were referred to as "joint adventures" rather than
"joint ventures," but in recent years "joint venture" seems to have become
the preferred term. A substantial body of thought holds that the joint
48. See, e.g., Weaver, supra note 46. The term "joint venture" is, of course, not limited
to real estate. It will cover "all situations in which two or more persons or independent
firms join forces to achieve some common goal." Pitofsky, Joint Ventures Under the Antitrust Laws: Some Reflections on the Significance of Penn-Olin, 82 Harv. L. Rev. 1007
(1969). Professor Pitofsky, in discussing the organization of new producing and servicing
organizations by two or more companies as a form of "quasi-merger," says that the term
"joint venture" is a "vague and protean concept ....
of little use in categorizing structure
or conduct with particular market consequences." Id. The real estate joint venture, of course,
generally bears little or no resemblance to the Penn-Olin type quasi-merger.
The term "joint venture" has become popular also in connection with international
business undertakings. See, e.g., Tan Hun Hui, Legal Nature of Joint Ventures in Singapore,
2 Singapore L. Rev. 1 (1970); Conlee, A Developer Discusses Joint Ventures, 29 The
Mortgage Banker 59 (May 1969).
49. See Nason, Engaging in Real Estate Equity Investments With Another Party-Use
of the Joint Venture Vehicle, 21 Ass'n Life Ins. Counsel Proceedings 1 (1969). See also
Aronsohn, The Real Estate Limited Partnership and Other Joint Ventures (to be published
in 1 Real Estate Rev. No. 1 (Spring 1971)).
50. See Practising Law Institute, Joint Ventures in Real Estate (Real Estate Transcript
Series No. 12 (1970)).
51. "[Tlhe English law has never recognized joint adventures as an independent relation.
ship but has frequently referred to it as a particularized partnership, sometimes as a
'special' partnership." Mechem, The Law of Joint Adventures, 15 Minn. L. Rev. 644 (1931).
As pointed out by Professor Rowley, as early as 1808 it was said that persons were "Jointly
concerned" in an "adventure," but it was not "until the middle of the last century that
courts began to draw a distinction between partnership and joint adventures." 2 S. Rowley,
Partnership § 52.1, at 461 (2d ed. R. Rowley & D. Sive 1960), citing Lyles v. Styles, 15 F
Cas. 1143 (No. 8625) (C.C.D. Pa. 1808).
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REAL ESTATE EQUITY INVESTMENTS
venture is but a form of partnership 2 (a joint venture is often referred
to as a "partnership for a particular purpose"), while another group feels
that a joint venture can create a separate and distinct legal relationship.'
Both groups, however, agree that there are many points of similarity
between a joint venture and a partnership and very few differences
of any substance.' In a large and still growing body of decisions, many
courts have purported to establish that there is such a thing as a joint
venture, without successfully arriving at an adequate definition of what
it is or how it differs from a partnership."
This does not mean that definitions of a joint venture have not been
attempted. According to Professor Rowley, the most popular definition
is "a special combination of two or more persons, where in some specific
venture a profit is jointly sought without any actual partnership or corporate designation." 56 Professor Rowley states that the second most popular
definition is "[a]n association of two or more persons to carry out a
single business enterprise for profit.15 7 It is interesting to note that the
second definition does not differ greatly from the definition of a partnership contained in the UPA, i.e., "an association of two or more persons to
52. "The law of partnership is applied, point for point to all joint adventure controversies, and identical results are reached, under similar circumstances, no matter whether
the association is regarded as a partnership or a joint adventure." Mfechem, supra note 51,
at 666. See Ross v. Wllett, 76 Hun. 211, 213, 27 N.Y.S. 785, 786 (Sup. Ct. 1894), where
the court stated: "A joint venture is a limited partnership, not limited in a statutory sense
as to liability, but as to its scope and duration, and under our law joint adventures and
partnerships are governed by the same rules." See also United States v. Wholesale Oil Co.,
154 F.2d 745, 747 (10th Cir. 1946), where the court said: UA joint venture Is but one form
of partnership...."
53. See Comment, joint Venture or Partnership, 18 Fordham L. Rev. 114 (1949),
which states that joint venture and partnership "are separate concepts, serving separate
ends and susceptible of independent interpretation in the law." See also 2 S. Rowley, supra
note 51, § 52.1, at 461, where it is said: "The ever increasing number of cases in which
specific associations are deemed joint adventures, and in which the legal principles said to
be applicable to joint adventures, as such, are applied, is ample proof, however, that such
a separate body of law does exist, however vague its theoretical outlines may be." See
generally Note, Partnership and Joint Venture Distinguished, 33 Harv. L. Rev. 852 (1920).
54. "Due to the fact that in the greater number of instances the law of joint adventure
and partnership parallel each other, it may not appear to make any difference whether the
relation is designated a joint venture or a partnership." Comment, supra note 53, at 122.
55. "Precise definition of a joint venture is difficult. The cases are of little help since
they are generally restricted to their own peculiar facts. 'each case in which a coadventure
is claimed ... depends of course for its results on its own facts, and owing to the multifariousness of facts, no case of coadventure rises higher than a persuasive precedent for
another.'" United States v. Standard Oil Co., 155 F. Supp. 121, 148 (SD.N.Y. 1957), ad,
270 F.2d So (2d Cir. 1959), quoting Harris v. Morse, 54 F.2d 109, 113 (S.D.N.Y. 1931).
56. 2 S. Rowley, supra note 51, § 52.2, at 464 (footnote omitted).
57. Id. (footnote omitted).
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carry on as co-owners a business for profit."5 8 The joint venture definition
deletes the words "as co-owners," and substitutes for "a business" the
words "a single business enterprise." Thus it removes a term which
describes a legal relationship, but adds a requirement that the association
be for a limited purpose.
These differences may shed some light on what a joint venture really is
or should be. Perhaps the words "joint venture" do not in themselves
create or describe a legal relationship at all. Perhaps the words merely
describe the purpose or intent of the parties to act in concert with respect
to a particular activity or series of activities limited either in time or in
scope. The actual legal relationship between the parties or with third
parties would be governed by general principles of law, depending upon
what the agreement between the parties says, what the parties intend,
what their activities are, and what authority or apparent authority they
have conferred upon one another.
When Jack and Jill went up the hill to fetch a pail of water, they may
have been joint venturers. If their parents had promised them a cookie
to share between them for bringing the water back, their activities would
seem to fit at least within the most popular definition of a joint venture
cited by Professor Rowley. But, although this may have been a joint
venture, it is doubtful that anyone would maintain that Jack and Jill were
partners and subject to the UPA.
On the other hand, let us assume that Jack and Jill, having reached
majority, decide to build and operate the Hilltop Hotel. They enter into
an agreement establishing a non-corporate entity called "Hilltop Associates" which will hold title to the real estate, and set forth in the agreement the rights, powers, duties and obligations they each have in connection with the construction and operation of the hotel, with provisions
pertaining to the sharing of profits and losses, and requirements to the
effect that they each will devote full time to the operation of the hotel.
Now Jack and Jill would seem to be partners and subject to the UPA, if
that law is in effect in the applicable jurisdiction. However, the words
"joint venture" might be an inappropriate description of their enterprise
since, if the words "joint venture" mean anything, they probably mean
that the parties intend an activity or activities limited in some way as to
time or scope. While it is true that this activity is limited to a specific
hotel, both Jack and Jill have agreed to devote their full time to the proposed activities for an indefinite period, and thus they may not fit within
what was probably intended by the words "specific venture" or "single
business enterprise" in the above-mentioned definitions of "joint ven58.
Uniform Partnership Act § 6(1) [hereinafter cited as U.P.A.].
1971]
REAL ESTATE EQUITY INVESTMENTS
ture." 59 Nevertheless, whether they are joint venturers or not, their legal
relationship would be that of partners.
Between these two extremes, there are any number of combinations,
three of which might be as follows:
(a) Suppose Jack and Jill became involved in numerous real estate developments, some together, some individually, and some with third parties.
Now they plan to purchase the hill in the name of a non-corporate entity
called the "Hilltop Venture," build garden apartments and either operate
them through a manager they will hire, or sell the property to a third
party after construction-all under the terms of a detailed agreement
setting forth, as in connection with the hotel discussed above, their rights
and duties. This time, however, the agreement provides that each may
engage in any other activities without obligation to the other partner. It
would seem that the purpose of the parties is concerted activity limited to
a single project, i.e., a joint venture. Their legal relationship within the
scope of the venture, however, would probably still be that of partners.
(b) Assume the same facts, except that the property is not owned by
the Hilltop Venture but by Jack and Jill as tenants in common, each
0 It would seem that they are still
having an undivided one-half interest.1
joint venturers and, in operating the property, still in the legal relationship
of partners. 1 As a matter of fact, prior to the UPA, when partnerships
could not hold title to real estate, this would have been the most usual
form a partnership would take. 2
(c) Now assume that Jack, an accountant in state A, and Jill, a nurse
in state B, acquire as tenants in common fee title to a hill in state C. The
hill is under lease to the United States Army for a radar installation.
Jack and Jill agree to hire a real estate management firm as managing
agent to collect the rents, pay the taxes and insurance, and forward onehalf of the net income to each of them. Possibly they are joint venturers,
59. The definitions seem to be aiming at a limitation as to scope, purpose or time.
Bromberg states that a joint venture "is a business association distinguishable from a
partnership (if at all) only by narrowness of purpose and scope. A partnership may be
formed for a single undertaking, but is usually intended to encompass an indefinite number
of transactions within a relatively broad line of business for an indefinite duration., A.
Bromberg, Partnership § 35, at 189 (1968). Rowley states: "'The principal difference between a partnership and a joint venture is said to be that while a co-partnership is ordinarily
formed for the transaction of a general business of a particular kind, a joint venture is
usually, but not necessarily, limited to a single transaction?" 2 S. Rowley, supra note 51,
§ 52.14, at 482 (footnote omitted).
60. See part IV A infra.
61. See UPA. § 7(2), which states that part ownership, including tenancy in common
"does not of itself establish a partnership, whether such co-owners do or do not share any
profits made by the use of the property."
62. See id. § 8, Comment.
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but they are probably not partners. Their legal relationship would not
seem to amount to a partnership arrangement, since they would not seem
to have established an association under which either would have the
powers normally afforded one partner to bind the other."3
A court in situation (c) would want to look at the terms of the relationship in order to determine whether a partnership had been created. The
point being made here is that from a legal standpoint a joint venture is
what the parties wish to make of it. It can be the same as a partnership,
or it can be different. The fact that the words "joint venture" are used
should not in itself result in legal consequences. The legal consequences
of a joint venture will depend, then, on what the parties have agreed to
do, and actually do.
If the above theory is correct, then many of the cases differentiating
between a partnership and a joint venture can perhaps be explained on
the ground that they were merely determining the rights and liabilities of
parties acting in concert, when their relationship did not amount to a
partnership. 4 Since this determination would depend on the facts of each
case, it would be understandable that the courts could not establish any
consistent rules with respect to "joint ventures" as such. There are, however, some differences often enunciated by the courts and commentators
as being generally applicable to what might be called non-partnership
joint ventures. These differences, which are more often apparent than
real, seem to revolve around the fact that any non-partnership joint
venture would not be subject to the UPA and its entity-aggregate compromise." For example, in a nonpartnership joint venture, it is said: (i)
63. As pointed out by Mechem, this has sometimes been referred to as a "tenancy-incommon-plus." See Mechem, supra note 51, at 664. Mechem's view was that joint ventures
are partnerships. He distinguished cases holding the parties to be joint venturers and not
partners as really involving nonpartnership "tenancies-in-common-plus." We would differ
with Mechem mainly in semantics and argue that they were nonpartnership joint ventures.
64. It has been said that a corporation can enter a joint venture where It could not
enter a partnership, notwithstanding the fact that the joint venture has all the attributes
of a partnership. If true, this would seem to constitute a legal distinction between joint
ventures and partnerships, under the rationale that a joint venture is limited in time or
scope and thus joining a joint venture would not constitute an undue abdication of
corporate authority. See H. Ballantine, Corporations § 88 (1946). As indicated in note 173
infra, however, the problem of corporate participation in a partnership is diminishing. Furthermore, in analyzing this question Professor Mechem found "practically no authority for
saying that a corporation can engage in a joint adventure where it could not also have
engaged in a partnership." Mechem, supra note 51, at 652. He concluded that "It seems
improbable that many courts are prepared to hold that the power and authority of a
corporation to participate in a joint adventure is substantially different than in the case
of partnerships." Id. at 653.
65. See part II B 3 infra.
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REAL ESTATE EQUITY INVESTMENTS
the venture could not hold title to real estate; 16 (ii) the venture would be
bound only by ordinary agency rules with respect to one venturer's right
to bind the other; 67 (iii) the venture might not be "dissolved" on the
death or withdrawal of a venturer;"8 (iv) the venture may not become
a voluntary bankrupt;6 9 and (v) one venturer could sue the other at law
with respect to transactions of the venture.1
°
66. A nonpartnership joint venture would not be subject to the UPA and thus could not
take advantage of UPA section 8(3), which permits the partnership to hold title to real
property. Title to joint venture property would therefore be held in the name of one
venturer on behalf of the joint venture, or in the name of the venturers as tenants in
common or joint tenants. See 2 S. Rowley, supra note 51, § 52.33.
67. Here again the cases dealing with joint ventures seem in conflict. See Keyes v.
Nms, 43 Cal. App. 1, 9, 184 P. 695, 698 (Dist. Ct. App. 1919), stating in dictum that
"[in a joint adventure, no one of the parties thereto can bind the joint adventure." This
phrase has been quoted as supporting the theory that there is no mutual agency in a joint
venture. Compare Goerig v. Continental Gas Co., 167 F.2d 930, 932 (9th Cir. 1948)
("The liability of the joint adventurers in the State of Washington is that of co-partners.'),
with Bryce v. Bull 106 Fla. 336, 343, 143 So. 409, 411 (1932) ("[Elach one of several
joint adventurers has power to bind the others in matters which are strictly within the
scope of the joint enterprise."). It would seem that in a nonpartnership joint venture, the
venturers should be liable to third parties for acts of their coventurers, to the extent they
have conferred, by agreement or by their actions, authority on their coventurer to act for
them. As pointed out by Bromberg, "[ejach venturer has authority to act and bind
within the . . . . actual or apparent scope of the venture." A. Bromberg, supra note 59,
§ 35, at 193-94; see Restatement (Second) of Agency § 159 (1958).
68. See 2 S. Rowley, supra note 51, §§ 52.37, 52.38.
69. Section 5 of the Bankruptcy Act permits partnerships to file voluntary petitions
in bankruptcy and permits involuntary petitions to be filed against partnerships. Bankruptcy Act § 5, 11 U.S.C. § 23 (1964). Such rights would seem inapplicable to nonpartnership joint ventures unless they could be considered "unincorporated companies"
within the definition of "corporation.' Id. § 1(8), 11 U.S.C. § 1(8) (1964). Compare the
discussions of a similar problem in an earlier version of the Bankruptcy Act in Mechem,
supra note 51, at 655, and Comment, supra note 53, at 130.
70. Miller v. Walser, 42 Nev. 497, 181 P. 437 (1919). Partners normally must sue in
equity for an accounting with respect to transactions of the partnership. See discussion in
part IV B 2 infra. Nonpartnership joint venturers, however, may also sue for an accounting. In the Miller case, the court said: "The principal distinction between a partnership and
[in a joint venture] one party may sue the other at law for
a joint adventure is that ...
a breach of the contract; but this right will not preclude a suit in equity for an accounting." Id. at 513, 181 P. at 442. Many courts, however, hold that with respect to transactions
relating to the venture, the venturers cannot sue each other at law during the existence of
the venture. See Danelian v. McLoney, 124 Cal. App. 2d 435, 268 P.2d 775 (Dist. Ct. App.
1954), where the court held that the action between former venturers was not barred by
the statute of limitations since a "joint venturer has no cause of action for a breach of
duty owed to the venturer until the firm has been dissolved and an accounting has been
had." Id. at 441, 268 P.2d at 779; see Consolidated Mach. & Wrecking Co. v. Harper Mach.
Co., 190 App. Div. 283, 180 N.Y.S. 135 (1st Dep't 1920).
The cases giving venturers the right to sue each other have been explained on the ground
FORDHAM LAW REVIEW
[Vol. 39
2. "Badges" of Partnership
Regardless of what theory or meaning of "joint venture" is adopted,
the parties will be in the legal relationship of partners if their acts and
powers constitute them as such. What acts or powers are considered in
order to determine whether the relationship justifies the designation of
such persons as "partners" has been rather thoroughly discussed in cases,
treatises, and law review articles. 7' Section 6(1) of the UPA defines
partnership as "an association of two or more persons to carry on as coowners a business for profit." As explained by Professor Rowley, this
definition "outlines all of the requisites of a partnership,17 2 the most
important of which, according to Professor Bromberg, are co-ownership
(including profit sharing and joint controls) and association (including an
intention to form a partnership).78
The elements of partnership as contained in the UPA definition will not
be dwelled upon here, although "each word of the definition requires
further explanation and delimitation before, under a given act [sic] of
circumstances, a partnership can be determined."74 It would seem clear
that the equity investment contemplated in this article, which includes the
exercise of controls by the institutional investor (as well as the developer)
over the operation of the property, would constitute the parties general
partners in most situations.7 r Thus, regardless of whether the parties are
considered to be joint venturers, if they form an association to operate
the property, with each having a share of control over the management of
the property and each sharing profits and losses, it would be difficult to
say that they are not partners and subject to the UPA provisions concerning their legal relationships with each other and third parties.
3. Use of the Term
If, then, the institutional joint venture would in most situations constitute a partnership, is there any advantage to using the term "joint
that "their transaction has usually been a single one and when it is completed, their
financial status is readily discernible." Comment, supra note 53, at 129. Mechem, In a very
thorough examination of the cases, found no difference between partnership and joint venture
with respect to the right to sue at law. He felt the test applicable to both is whether the
affairs of the partnership or joint venture have been sufficiently liquidated or accounted for
so as to permit an intelligent judgment. Mechem, supra note 51, at 645-51.
71. See generally United States v. Neel, 235 F.2d 395 (10th Cir. 1956); Rizzo v. Rlzzo,
3 II. 2d 291, 120 N.E.2d 546 (1954); Northampton Brewery Corp. v. Lande, 138 Pa.
Super. 235, 10 A.2d 583 (1940); A. Bromberg, supra note 59, ch. 2; F. Mechem, Elements
of the Law of Partnership, ch. IV (2d ed. 1920); 1 S. Rowley, Partnership, d. 7 (R.
Rowley ed. 1960); 1 Calif. L. Rev. 482 (1913); 16 Minn. L. Rev. 115 (1931).
72. 1 S. Rowley, supra note 71, § 6.1.
73. A. Bromberg, supra note 59, § 4, at 35.
74. 1 S. Rowley, supra note 71, § 6.1.
75. See part n B 2 &3 infra.
1971]
REAL ESTATE EQUITY INVESTMENTS
597
venture" in the name of the partnership, or in connection with the transaction?
The use of the term joint venture should not change the legal relationships of the parties, even if the theory that a joint venture does not involve
legal relationships is not accepted by the courts. If the parties are acting
as partners, they most likely will be held to be partners regardless of what
they call themselves However, there still may be some specific advantages to using the "joint venture" term. Since it is the popular name, its
use helps to define what is being done, while providing a convenient name
to give to a variety of possible structures creating varying legal relationships which may not be fully determined until after extensive negotiations.
Also, the use of "joint venture" may afford some protection against unauthorized acts by a partner. As will be discussed in more detail below,77
each partner is liable for the acts of the other within the scope or apparent
scope of the business. Since the use of the term "joint venture" normally
implies an intention by the parties to act in concert with respect to an
activity or activities limited in time or scope, the fact that these words are
contained in the tile of the business may tend to make it more difficult
for a third party to argue that the partner acting beyond the authority
conferred upon him had apparent authority to so act.78
B. The Legal Relationship
As has been discussed, whether or not the parties call themselves or
are called "Joint Venturers," the legal relationship is usually that of a
general or limited partnership.70 Other forms of investment have been
employed, but on the whole they have seemed less desirable.
1. Corporations and Trusts
The corporate form has the advantage of limited liability.8 However,
income tax considerations usually will dictate against its use. In the early
years of the real estate equity investment, the project probably will
operate at a loss for tax purposes because of the combined effects of low
76. "Except in rare cases where the evidence is conclusive, the issue as to whether or
not a partnership exists is a question of fact. . . . It is the substance and not the name or
form of the relationship that constitutes the legal relationship of the contracting parties."
Seaboard Sur. Co. v. H & R Constr. Corp., 153 F. Supp. 641, 646 (D. Blnn. 1957), modified
sub. nom. Nelson v. Seaboard Sur. Co., 269 F.2d 882 (8th Cir. 1959).
77. See part IV C 2 infra.
78. See id.
79. See part T C infra.
80. Present always is the "veiled" threat that in some circumstances a court may pierce
the corporate entity. The general rule, however, is that "the corporateness-with attendant
corporate attributes-will be recognized and will not be disregarded." H. Henn, Corporations
§ 143, at 204 (1961). For a discussion of the exceptions to this general rule, see part Ii C
infra.
FORDHAM LAW REVIEW
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rental income and large deductions for depreciation, mortgage interest,
and operating expenses. The use of the corporate form prevents the offsetting of these tax losses against other income of the parties, 81 whereas
the partnership vehicle permits the deduction of the losses by the partners
from their personal income on a current basis. 2 Once the real estate
equity investment crosses into the black for tax purposes, investors using
the corporate form must also consider the possibility of taxation at two
levels, i.e., the corporation level and the shareholder level when the profits
are distributed. This problem may be of much greater concern to the
developer (if an individual) than to the institutional investor, since
dividends to the institutional investor (even if it is a taxable entity) will
qualify for the corporate eighty-five percent "dividends received" deduction." Use of the corporate device in such circumstances could give rise
to considerable conflict between the parties as to dividend policy since
the individual investor can be expected to favor retention of profits by
the corporation and an eventual bail-out at long-term capital gains rates84
whereas the institutional investor may wish profits distributed as earned.
The problem of double taxation may be mitigated somewhat by having
the parties make their investment through the vehicle of bona fide debt
as well as stock investment, rather than through stock exclusively.8" Some
of the profits of the corporation are thus paid out as interest deductible
by the corporation, 0 rather than as non-deductible dividends.
The parties may also discover that use of the corporate form can result
in increased taxation at the state level, depending upon the laws of the
particular jurisdiction involved. Even if there was no tax disadvantage,
or if the tax disadvantage was acceptable to the institutional investor,
the corporate form may nevertheless be precluded by statutes regulating
the investments of institutional lenders. These statutes would often prevent the institution from acquiring substantial 87percentages of the outstanding common stock of the corporate vehicle.
Another possibility is the use of a form of business or other trust.88
81. Since the institutional investor is not an individual, an election of "Subchapter S"
treatment for the corporation is not available. Int. Rev. Code of 1954, § 1371(a)(2).
82. Id. § 702.
83. Id.§ 243(a)(1).
84. Id.§ 331.
85. See discussion in part II B 1 infra.
86. Int. Rev. Code of 1954, § 163(a).
87. With respect to insurance companies, see N.Y. Ins. Law § 81(13) (McKlnney Supp.
1970) ; with respect to national banks, see 12 U.S.C. § 24 (Supp. V, 1970).
88. Having its origin in Massachusetts, the business trust is a form of unincorporated
business organization created by a declaration of trust, under which the management Is
"conducted by compensated trustees for the benefit of persons whose legal interests are
1971]
REAL ESTATE EQUITY INVESTMENTS
Here a trustee would own legal title to the property and the beneficiaries,
or cestuis-que trust, would be the institutional lender and the developer.
Normally in a trust situation the beneficiaries would not be personally
liable. As explained by Profesor Scott, a trustee "is not empowered to act
on behalf of the beneficiaries personally ....
He may have power to sub-
ject the trust property to the claims of third persons, but he is not the
agent of the beneficiaries and has no power to subject them to such
claims.... The trustee is said to be agent for the trust estate and not
agent of the beneficiaries." 9 However, if the trust were a "dry" or "passive" trust, under which the beneficiaries exercise control over the trustee
in the operation of the property, the beneficiaries might lose their limited
liability." Furthermore, "it is exceedingly difficult to make any accurate
statement as to what powers may be given to the shareholders"' without
subjecting them to personal liability."9 2 While an active and not a "dry"
trust might preserve limited liability, the institutional investor, even as
represented by transferable certificates of participation, or shares." Comment, MAsachusebtts
Trusts, 37 Yale L.J. 1103, 1105 (1928). See generally G.G. Bogert & G.T. Bogert, The Law
of Trusts and Trustees § 291 (2d ed. 1964); Magruder, The Position of Shareholders in
Business Trusts, 23 Colum. L. Rev. 423 (1923).
89. 3 A. Scott, The Law of Trusts § 274 (3d ed. 1967). Professor Scott points out. however, that where the trustee, in addition to his duties as trustee, "has undertaken to act for
the beneficiaries and under their control, he is also their agent, and as such can subject
them to personal liabilities by acts done by him within the scope of the employment." Id.
at 2304.
90. "It is uniformly held that, if the cestuis may dictate on questions of the management of the trust, they are liable for the debts. The liability is usually rested on the
theory that the organization is not then a trust but a partnership or joint stock association
in which the trustees are mere agents." G.G. Bogert & G.T. Bogert, supra note 88, § 294;
see Restatement (Second) of Agency § 14B (1958). A joint stock association or joint stock
company, referred to by Bogert, wanders somewhere between corporation and partnership, with centralized management, continuity of life, transferability of interest, unlimited
liability of the shareholder, and taxation as a corporation. See generally A. Bromberg, supra
note 59, § 34. The combination of entity taxation and general liability make the joint
stock association inappropriate for institutional real estate equity investments.
91. In business trusts, the holder of the trust certificates, or the cestuis or beneficiaries
of the trust, are often referred to as "shareholders."
92. G.G. Bogert & G.T. Bogert, supra note 88, § 297, at 593. Messrs. Bogert indicate
that one test generally approved is whether the shareholders "have reserved powers suffident to enable them as a practical matter to control the business." Id. Judge Magruder
felt that shareholders of a business trust might be held to be partners "not because they
have some meeting or association together, but because by virtue of powers in the trust deed
they may fairly be said to be carrying on the business." Magruder, supra note 88, at 432. It
would seem that the power to remove trustees (see Neville v. Gifford, 242 Mass. 124, 136
N.E. 160 (1922)), or to alter or amend the declaration of trust (see Simson v. Klipstein,
262 F. 823 (D.N.J. 1920)), would render the shareholder liable, although even these condusions have been subject to some criticism on the ground that the shareholders should not
be held to be partners, at least until they really begin to exercise control over management.
FORDHAM LAW REVIEW
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beneficiary, may feel that he must exercise some control over management, at least as to major
decisions affecting the property and the liabil3
ities of the parties .
Furthermore, since centralized management is common to both corporations and business trusts, such trusts are generally taxed as corporations, 4
thus raising again the problem of double taxation. The specter of being
subjected to double taxation, while losing limited liability as the result of
the retention of what the institutional investor considers the barest of
controls, has frequently led to avoidance of the trust route. Thus the
standard vehicle for equity investments by institutional lenders has become a form of partnership, either limited or general.
2. Limited Partnerships
Sometime during the middle ages, as early as the twelfth century,90 the
first commendator gave money to the first commendatarius, and the
limited partnership was born. The commendator received a portion of the
profits, usually the major portion, but was not personally liable for the
losses. The commendatariushad control over the money and the operation
of the business.00 In Louisiana, a limited partnership is still known as a
'0 7
"partnership in commendam.
Today the limited partnership is strictly regulated by statute. The
Uniform Limited Partnership Act (ULPA), which was drafted by the
National Conference of Commissioners on Uniform State Laws" and is
in force in forty-five jurisdictions (including the major commercial states),
is specific in its requirements for the organization of the limited partnership. 9 Basically, the limited partnership is composed of one or more
general partners, whose rights and liabilities are very much akin to the
partners of a general partnership. Like the commendatarius, they have
control over the partnership and its assets. 10 There are also limited
93. See Part IV B 1 infra.
94. Treas. Reg. § 307.7701-4(b)
(1954); see Morrissey v. Commissioner, 296 U.S. 344
(1935).
95. "Limited partnerships were first
known and recognized in the Italian commercial
centers of Pisa and Florence in the twelfth century, as a means for the owners of wealth,
primarily the nobles and clergy, to invest their capital without being known or named." 2 S.
Rowley, supra note 51, § 53.0, at 550.
96. See generally A. Bromberg, supra note 59, § 26.
97. See La. Civ. Code Ann. art. 2839 (West Supp. 1970). See also Comment, Partnership in Commendam-Louisiana's Limited Partnership, 35 Tul. L. Rev. 815 (1961).
98. The ULPA was approved by the National Conference of Commissioners on Uniform
State Laws in 1916. This organization is composed of commissioners appointed by the
governors of the respective states. See Uniform Laws Annotated, Uniform Limited Partnership Act III (Master ed. 1969).
99. Uniform Limited Partnership Act § 2 [hereinafter cited as U.L.P.A.1.
100.
id.§ 9.
The general partners' powers are, however, restricted in a few specific areas. See
1971]
REAL ESTATE EQUITY INVESTMENTS
partners (one or more) who, like the commnendators, reap their share of
the profits,' 0 ' suffer no losses beyond their initial investment, and have
little or no say about what goes on. 0 2 It is these elements of the limited
partnership which make it both desirable and undesirable as a vehicle for
equity investment by the institutional lender.
(a) Control. Limited liability is certainly a desirable end. But ULPA
section 7 provides that: "A limited partner shall not become liable as a
general partner unless, in addition to the exercise of his rights and powers
as a limited partner, he takes part in the control of the business."'"
The ULPA does not say what constitutes taking part in control of the
business, or what the rights and powers of a limited partner are. It does,
however, list in section 10 "rights" of a limited partner which can be
exercised without losing limited liability under the language of section 7.
Section 10 provides that the limited partner has the rights of a general
partner to require the maintenance and inspection of partnership books,
a formal accounting of partnership affairs, and a dissolution and winding
up by court decree. Section 10 also provides that the limited partner has
the right to receive a share of the profits, and the return of his contribution
as provided in sections 15 and 16. Also, while stating that the general
partners have control over the partnership, section 9 provides that general
partners must obtain the consent of all the limited partners prior to doing
any one of several things-including acting in contradiction of the certificate, doing anything that would make it impossible to carry on the business,
confessing judgment for the partnership, or admitting general or limited
partners. It would seem that these required consents can be given or
withheld by the limited partner, without losing limited liability, as part
of the "rights and powers" of the limited partner under section 7.
The limited partner has other rights and powers under the UILPA, such
as the right to lend money to the partnership under section 13. But it is
not clear whether the rights and powers referred to in section 7 were intended to go beyond those specifically mentioned in the statute. What
rights and powers the limited partner may exercise in the partnership
agreement, in addition to his slim statutory rights, and still pass muster
under section 7 is therefore uncertain. For example, would the right to
be consulted on major decisions constitute taking part in the control of
the business beyond the rights and powers of limited partners? What
about a veto power over purchases or sales of partnership assets? California tried to set some guidelines by amending its TJLPA in 1963. The
amendments provided that limited partners could vote for the election
of general partners, the termination of the partnership, amendments to
101.
102.
103.
Id.
§
Id.
§ 7.
Id.
10(2).
FORDHAM LAW REVIEW
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the partnership agreement, and sale of all or substantially all of the
partnership assets, without losing limited liability.10 4 Outside of California
there seems to be no legislative help, and the cases are too few and do
not seem to set any guidelines.1 05 In a recent article,100 the problem of
control by the limited partner was considered, and that author concluded:
[T]he most persuasive [construction of the control test] is to measure it by the most
logical rationale for holding the limited partner liable: to prevent third parties from
mistakenly assuming that the limited partner is a general partner and relying on his
general liability. . . . Under this view . . . only activities which conceivably could
induce reasonable reliance, such as supervision of the partnership's day-to-day ac107
tivities, should produce general liability.
This is the most liberal of the possible constructions the author discussed.
Yet, with no certainty as to the outcome, he did not feel that counsel
could permit a limited partner to engage in a regular practice of giving
"advice" to the general partners.1 08
Thus the institutional investor is torn between trying to protect its
assets through limited liability on the one hand, and through taking part in
the control of the business on the other. Institutions do not wish to
invest money with no voice as to over what is done with it. The fear, however, is that the exercise of any power might be considered control within
the meaning of the ULPA.
104. Cal. Corp. Code § 15507 (West Supp. 1971); see ch. 870, § 7 [1963] Cal. Stat. 2113,
stating that the amendment to section 7 of the ULPA "shall be construed as a clarification
and a continuation of existing law and shall not be construed as constituting changes
therein."
105. See Feld, The "Control" Test For Limited Partnerships, 82 Harv. L. Rev. 1471,
1474-75 (1969). The author states that apart from cases where the limited partners are
clearly responsible for the enterprise and thus liable as general partners (e.g., Holzman v.
DeEscamilla, 86 Cal. App. 2d 858, 195 P.2d 833 (Dist. Ct. App. 1948)), "there appear to
be only three cases in which the courts have had to confront the issue of what and how
much a limited partner may do with impunity, and in none have they managed satisfactory
descriptions of the standards by which to judge the partners' activities." Id. at 1475. The
three cases are Granger v. Antoyan, 48 Cal. 2d 805, 313 P.2d 848 (1957) (auto distributorship sales manager-limited partner who supervised sales people and cosigned checks as convenience to general partner was not exercising control); Silvola v. Rowlett, 129 Colo. 522,
272 P.2d 287 (1954) (foreman-limited partner of auto shop who could purchase parts but
not extend credit was not exercising control); and Rathke v. Griffith, 36 Wash. 2d 394,
218 P2d 757 (1950) (no liability notwithstanding execution of a few documents by the
limited partner and unused by-law provision making limited partner a "director").
106. Feld, supra note 105.
107. Id. at 1479.
108. Notwithstanding Plasteel Prods. Corp. v. Heiman, 271 F.2d 354 (1st Cir. 1959),
which permitted advice by the limited partner, Mr. Feld stated that "in view of the weight
[investing partners'] advice is likely to carry .....
this relationship may, as a practical
matter, give any 'advice' the color of a command in the partnership." Feld, supra note
105, at 1477.
1971]
REAL ESTATE EQUITY INVESTMENTS
(b) PartnershipAssets as Security. Another problem of the limited
partnership is found in section 13 of the ULPA. Because of the importance of this section, both in substance and in form, it is set forth in full
below:
§ 13. Loans and other business transactions with limited partner.
(1) A limited partner also may loan money to and transact other business with
the partnership, and, unless he is also a general partner, receive on account of resulting claims against the partnership, with general creditors, a pro rata share of the
assets. No limited partner shall in respect to any such claim
(a) Receive or hold as collateral security any partnership property, or
(b) Receive from a general partner or the partnership any payment, conveyance,
or release from liability, if at the time the assets of the partnership are not sufficient
to discharge partnership liabilities to persons not claiming as general or limited
partners,
(2) The receiving of collateral security, or a payment, conveyance, or release in
violation of the provisions of paragraph (1) is a fraud on the creditors of the part109
nership.
On its face, subsection (1) (a) says that a limited partner may not
receive or hold partnership property as collateral security, and subsection
(2) says that receiving such security is a fraud on creditors of the partnership. Since the institutional investor, as a limited partner, will also often
be a holder of a mortgage on partnership assets, this section, if it means
what it seems to say, may have serious consequences. 110
However, the case law (what there is of it) says that the section does
not mean what it seems to be saying. The leading case is Hughes v.
Dash.j1 In that case the trustee in bankruptcy of the limited partnership
sought to have the mortgage, made by the limited partnership to the
limited partner, declared null and void as against the trustee, pursuant to
the Florida counterpart of section 13 of the ULPA. At the time the mortgage was made, the partnership was solvent. The fifth circuit held that
the mortgage was valid and good against the trustee. Judge Bell addressed
himself directly to the problem and held that the qualifying language of
subsection (1) (b), which prohibits a limited partner from receiving any
109. U.L,.A. § 13.
110. Section 13 is not as artfully drawn as it might have been. As a result, it is possible
to argue that it only prohibits taking security with respect to a claim that arises in connection with a pre-existing debt, since the section provides that a limited partner may loan
money to the partnership but may not receive partnership property as collateral security
with respect to a "resulting claim" against the partnership. In this connection see the
California amendment to section 13 (see text accompanying note 126 infra), which made
the existing language of subsection (1) (a) applicable only on insolvency, and also added an
additional clause prohibiting a limited partner from making a loan on the security of
partnership property if the partnership is insolvent at the time the secured loan is made.
See note 117 infra.
111. 309 F.2d 1 (5th Cir. 1962).
FORDHAM LAW REVIEW
[Vol. 39
payment, conveyance, or release only "if at the time the assets of the
partnership are not sufficient to discharge partnership liabilities to persons
not claiming as general or limited partners, 1 2 is also applicable to subsection (1) (a). For convenience, this qualifying language will be referred
to as the "insolvency qualification." He relied upon the Official Comment
of the Commissioners on Uniform State Laws with respect to this section, 1 3 which indicates an intention to apply the insolvency qualification
to both subsections. In the Comment, the Commissioners state that the
limited partner may loan money to the partnership,
provided he does not, in respect to such transactions, accept from the partnership
collateral security, or receive from any partner or the partnership any payment,
conveyance, or release from liability, if at the time the assets of the partnership are
11 4
not sufficient to discharge its obligations to persons not general or limited partners.
From the language, punctuation, and grammatical structure of this
Comment, it would seem that the statutory problem could have been
created by a printer's error. Had subsections (a) and, with the exception
of the insolvency qualification, (b) been indented and the insolvency
qualification brought out to the margin, the Hughes decision would clearly
be correct. 1 5 Whether a printer's error or not, the Commisioners' Comment does seem to indicate that the "mischief"1 1 " the drafters were aiming
at was that of a limited partner accepting security from an insolvent
partnership, and that this was all they intended to prohibit.
112. Id. at 2.
113. U.L.P.A. § 1, Comment Fifth. The Official Comments can be found following
U.L.P.A. § 1, in 6 Uniform Laws Annotated 562 (Master ed. 1960).
114. Id.
115. Last year a New Jersey case supported the Hughes decision. A.T.E. Financial Serv.,
Inc. v. Corson, 111 NJ. Super. 254, 268 A.2d 73 (Ch. 1970). The New Jersey Superior
Court held the insolvency qualification applicable to subsection (a). See also Granger v.
Antoyan, 48 Cal. 2d 805, 313 P.2d 848 (1957), where the limited partner held a chattel
mortgage on partnership assets. The Supreme Court of California, based upon a review of
the evidence, held that the limited partner had not violated § 15513 of the Corporations
Code [U.L.P.A. § 131. Although the court did not discuss the problem of the application
of the insolvency qualification to subsection (a), its decision would seem to have assumed
it. The Granger case was decided prior to the amendment discussed in note 110 supra.
116. See de Sloovere, Contextual Interpretation of Statutes, 5 Fordham L. Rev. 219
(1936); Frankfurter, Some Reflections on the Reading of Statutes, 47 Colum. L. Rev. 527
(1947).
117. Where a limited partner makes a loan to the partnership and receives contemporaneous collateral security, it is not entirely clear why section 13 of the ULPA should consider this "mischief," even if the partnership is at the time insolvent. Such loan and security
would not be considered an unlawful preference under section 60(a) of the Bankruptcy
Act, but would seem to constitute a fraudulent conveyance under section 67 of the Bankruptcy Act and under section 8 of the Uniform Fraudulent Conveyance Act (UFCA). See
1971]
REAL ESTATE EQUITY INVESTMENTS
However, other legislative history, at least in New York, still casts
some doubt on this conclusion. In a letter on the stationery of the Commissioners on Uniform State Laws, New York State Board, dated March
21, 1922 and found in the Governor's Jacket l8 on the ULPA 10 Carlos
C. Alden, a New York Commissioner, wrote to the Honorable C. Tracey
Stagg, counsel to the Governor, urging approval by the Governor of the
ULPA. The letter commented "only on the most important changes which
it [the ULPA] will make in our existing law."" ° Section 13 was one of
the three sections discussed in the letter. Mr. Alden's comment was as
follows: "Under § 13, a limited partner may not secure a preference on
partnership assets, upon a loan of money to it, through the taking of
collateral security. This is not prevented under our present statute, and
seems a proper safeguard to add to our law." Most of the foregoing was
also embodied in a memorandum from Mr. Stagg apparently to the
Governor, also found in the Governor's Jacket, in which he stated the bill
"merits approval." In addition, the Association of the Bar of the City of
New York, in approving the bill, used the exact language quoted above
from Mr. Alden's letter. 21 Thus there is some indication that the New
York drafters of 1922 intended a result somewhat different from that
intended by the drafters of the original uniform act, which had been
part II C 3 infra. The giving of security may be the only way to induce such a partner,
who is not liable for the debts of the partnership, to infuse new cash into an insolvent
enterprise. The limited partner may be the only source of available funds, and it is possible
that investment of those funds might greatly benefit both the partners and their creditors
by saving the partnership.
118. See Breuer, Legislative Intent and Extrinsic Aids to Statutory Interpretation in
New York, 51 Law Library J. 2, 8-9 (1958).
119. The ULPA was adopted in New York in 1922. Law of April 13, 1922, ch. 640 (1922]
N.Y. Laws 145th Sess. 1750.
120. Prior to the adoption of the ULPA, the New York statute provided that a limited
partner could loan money to the partnership and "take and hold the notes, drafts, acceptances
and bonds of or belonging to the partnership, as security for [its] repayment." Law of
April 14, 1857, ch. 414, § 17, [1857) N.Y. Laws 80th Sess. 836, 837 (repealed 1922). It did
not expressly prohibit taking other partnership assets as security.
New York had had a limited partnership law for 100 years prior to the enactment of the
ULPA. The first statute was passed in 1822, and became the example for several states. Law
of April 17, 1822, ch. 244 [1822) N.Y. Laws 45th Sess. 259 (repealed 1828); see N.Y.
Limited Partnership Law § 90, n.1 (McKinney 1948), citing Moorhead v. Seymour, 77 N.Y.S.
1050 (City Ct. 1901), which further traces the New York statute to the French Code with
respect to La Societe en Commandite.
121. The Report of the Association of the Bar of the City of New York was prepared
by its Committee on the Amendment of the Law of Association and is found in the Governor's Jacket. See note 20 supra.
FORDHAM LAW REVIEW
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approved by the General Conference of the Commisioners on Uniform
State Laws in 1916.
Another problem revolves around the language of section 13 which
states that a limited partner may not "receive or hold as collateral security any partnership property,'112 2 and also the insolvency qualification
which (under the Hughes interpretation) would permit such security
"if at the time' 12 the partnership was not insolvent. Assuming that the
insolvency qualification does apply, and that a limited partner could
receive partnership assets as security if no insolvency existed or was
created, what would happen if the solvent partnership later became insolvent? Although the security was undoubtedly to protect against such
a circumstance, the emphasized language quoted above would seem to say
that a limited partner could not hold the collateral once the partnership became insolvent. This result hardly makes any sense, and the
language seems to have been ignored by the cases and commentators.
Indeed, subsection (2) makes only the receiving of collateral security in
violation of section 13 a fraud on creditors. Thus the penalty provided
would not seem applicable to holding security in violation of the section.
This apparent inconsistency might indicate that the drafters12 used
the
4
words "or hold" loosely, without fully considering their effect.
Undoubtedly, section 13 of the statute needs some clarification. Some
jurisdictions have attempted to do so. 12 5 Most recently, in 1970, the
California legislature amended its statute and provided in a separate
subsection that secured loans to the partnership by a limited partner
would not be valid if at the time the loan was made the partnership assets
were not sufficient to discharge debts to outsiders. 20
122. U.L.P.A. § 13(1)(a) (emphasis added).
123. Id. § 13(1) (b) (emphasis added).
124. A possible interpretation of the "or hold" language is that the drafters believed
a limited partner would, under some circumstances, hold partnership assets for reasons other
than security. If such property already held by the limited partner were converted to collateral security, the limited partner would not technically fit within the "receive . . . as
collateral security" language. Such an interpretation, however, would not explain the failure
to include "or hold" in subsection (2) of section 13.
125. See Conn. Gen. Stat. Rev. § 34-13 (1961); Hawaii Rev. Laws § 425-33 (1968);
N.H. Rev. Stat. Ann. § 305-14 (1966); Tenn. Code Ann. § 61-213 (1956), all of which adopt
the form and language contained in the Commissioner's comment (see note 113 supra) rather
than the official text, thus making the insolvency qualification applicable to U.L.P.A. § 13(1)
(a). But see S.D. Compiled Laws Ann. § 48-6-19 (1967) which, by placing U.L.P.A.
§ 13(1) (a) in a separate section of the statute, makes it clear that the insolvency qualification is inapplicable in South Dakota.
126. Cal. Corp. Code § 15513 (West Supp. 1971). The legislature declared that the amendment did "not constitute a change in, but is declaratory of, the existing law." Ch. 866, § 2,
[1970] Cal. Stat. 1604. See note 110 supra.
1971]
REAL ESTATE EQUITY INVESTMENTS
607
If, in the applicable state, the taking of security by a limited partner
should be held to violate the statute, the penalty provided in section 13
is that the transaction would be a fraud on creditors of the partnership.
Thus the mortgage would be invalid as to creditors and the trustee in
bankruptcy of the partnership.?
7
It follows that the mortgage should
parties.?28
Would the limited partner also lose
remain valid between the
limited liability? Probably not, since the fraud remedy is specified in
the section itself, and since in other portions of the ULPA where the
drafters intended a loss of limited liability they so specified. 9
The institutional lender's decision on whether to use a limited partnership may in the end depend upon local interpretations of the ULPA and
on the availability of title insurance covering the mortgage.'3 0 In any
event, the complexity of the problems of control and collateral security
and the magnitude of the risks appear to have turned some institutional
investors from the limited partnership to a general partnership as the
vehicle for equity investments. 31'
3.
General Partnerships
Many of the problems raised in connection with the limited partnership are avoided by the use of a general partnership, but all problems
are not resolved and some additional ones are created. Some of the
difficulty is conceptual and involves attempting to determine exactly what
constitutes a partnership.
The Uniform Partnership Act defines a partnership as "an association
127. The UFCA has generally been interpreted to render transactions that are fraudulent
as to creditors voidable at the option of those creditors. See 37 Am. Jur. 2d Fraudulent Conveyances § 106 (1968). The trustee in bankruptcy is, inter alia, a lien creditor on the day
of bankruptcy. See Bankruptcy Act § 70(c), 11 U.S.C. § 110(c) (1964).
128. 37 Am. Jur. 2d Fraudulent Conveyances § 111 (1968).
129. See, e.g., U.L.P.A. § 5.
130. A senior officer of one major national title company, in discussions with the authors,
has indicated recently that his company would consider (on a case by case basis) insurance of
mortgages on partnership real estate held by limited partners. If its study of the transaction
indicates that the limited partner's mortgage is for a valid business purpose and not to
"euchre" general creditors, the company would insure. The California Land Title Association
has, however, apparently at least tentatively decided to recommend that the policy insuring
a mortgage held by a limited partner contain an exception for the rights of creditors
of the partnership. But see text accompanying 126 supra.
131. Others, however, would prefer not to join general partnerships. See, e.g., Groothuis
& Cohen, Life Insurance Company Investments in Limited Real Estate Partnerships, 21
Ass'n Life Ins. Counsel Proceedings 433 (1971) (supporting the limited partnership approach).
Most institutions which have joined general partnerships have done so through one or more
subsidiaries rather than directly. For a discussion of the use of a subsidiary in connection
with the limited partnership approach, see part II C 2 infra.
FORDHAM LAW REVIEW
[Vol. 39
of two or more persons to carry on as co-owners a business for profit."' 1 2
But is a person dealing with an entity or with a group of individuals?
This question has been answered often but not always consistently. At
least some of the blame rests with the UPA itself.
When the Commissioners on Uniform State Laws, shortly after the
turn of the century, focused their attention on the preparation of a uniform partnership act, they selected Dean James Barr Ames as the principal drafter. 183 Dean Ames had submitted two drafts before he died in
1910.134 Had he been able to complete his job, many of the problems
faced by the institutional lender in operating under the UPA might have
been avoided, for Dean Ames was an advocate of the so-called "entity"
theory of partnership 3 -- a theory which regards a partnership as having
a legal personality separate and distinct from the individual legal personalities of each member. 136
To accomplish his purpose, in 1905 Dean Ames sought and procured
the Commissioners' instructions to draw the Act "'on the lines of the
mercantile [entity] theory of partnership.' "'37 When the "earnest, patient, and thorough . . . scholar"'M8 died, he had already acknowledged
that the "entity" theory was meeting some roadblocks in the form of
state constitutions, 3D but his final product might have embodied more
132. U.P.A. § 6(1).
133. This was announced at the 1903 meeting of the Conference of Commissioners on
Uniform State Laws. 26 A.B.A. Rep. 501 (1903).
134. For the history of the Act, see Commissioner's Prefatory Note to Uniform Partnership Act, 6 Uniform Laws Ann. 5-8 (1969).
135. See Lewis, The Uniform Partnership Act, 24 Yale L.J. 617, 639 (1915); Lewis, The
Desirability of Expressing the Law of Partnership in Statutory Form, 60 U. Pa. L. Rev. 93
(1911). For an interesting discussion of the "entity" theory, see Drake, Partnership Entity
and Tenancy in Partnership: The Struggle for a Definition, 15 Mich. L. Rev. 609 (1917).
136. Dean Ames would have defined a partnership as "a legal person formed by the
association of two or more individuals for the purpose of carrying on a business with a view
to profit." U.P.A. § 1(1) (Tent. Draft No. 2, 1909).
137. Resolution of the Commissioners on Uniform State Laws, Aug. 18, 1905, in 34
A.B.A. Rep. 1082 (1909). Dean William Draper Lewis, who eventually drafted the Uniform
Partnership Act, disliked the "entity" theory: "By its advocates it has also been called the
'mercantile theory,' on the assumption that business men . . . proceed on the . . . premise
on which the theory is based. Such an assumption however, is entirely unwarranted." Lewis,
The Uniform Partnership Act, supra note 135, at 639.
138. Beale, James Barr Ames-His Life and Character, 23 Harv. L. Rev. 325, 326 (1910).
139. Under several state constitutions, a partnership treated as an "out and out" legal
entity might be considered a corporation for the purposes of limited liability. Thus in these
states "it possibly could not be made lawful for more than double the individual contribution, which, of course, is quite at war with the whole conception of partnership." Address
of Dean James Barr Ames to a meeting of the Commissioners on Uniform State Laws, Aug.
24, 1908, in Report of the Committee on Commercial Law, 34 A.B.A. Rep. 1082 (1909).
1971]
REAL ESTATE EQUITY INVESTMENTS
of what Coleridge called the "shaping spirit of Imagination!"" than
does the UPA.
On Dean Ames' death, the Commissioners turned to Dean William
Draper Lewis. 41 Dean Lewis was an advocate of the "aggregate" theory,
the underlying idea of which is that "in partnership transactions the
individual partners deal directly with each other and with third persons,"
a theory which "is also called the common law theory of partnership,
.42
because ... the courts proceed on [its] underlying assumptions ....
Had the Act been redrawn to follow the aggregate theory completely,
many of the problems faced today might have been avoided. But apparently the Commissioners had traveled too far on the entity road to
turn back all the way. Upon his appointment, Dean Lewis, together with
James B. Lichtenberger of the Philadelphia Bar, prepared two drafts,
one embodying the "entity" idea and the other embodying the "aggregate" theory. In 1911 the Conference withdrew its 1905 instructions to
Dean Ames, 4 s so that the Act could be drafted to combine both theories.
Thus the UPA was conceived and ultimately born with a slightly
schizoid personality. 44 The UPA itself contains numerous provisions
140. S. Coleridge, Dejection: An Ode, in 1 The Complete Poetical Works of Samuel Taylor
Coleridge 362, 366 (E.H. Coleridge ed. 1957).
141. "[Tlhe substance, form and phraseology of the Act are principally the work of
Dr. William Draper Lewis and other members of the Philadelphia Bar. To these men is
due the fact that this Act adheres to the common law theories and ideas and in great part
conforms to the existing law in . . . States, rather than to the theories and ideas of the
legal fiction of an entity, as originally intended." Lichtenberger, The Uniform Partnership
Act, 63 U. Pa. L. Rev. 639 (1915) (footnote omitted).
142. Lewis, The Uniform Partnership Act, supra note 135, at 639.
143. Said Professor Williston: "[Ijt is to be said that we cannot escape from our past
legal history satisfactorily by a legislative fiat. We may trim and pare excrescences, and may
on new subjects create wholly new legal ideas by statute, but in subjects with a long past,
experience seems to show that it is difficult to adopt fundamentally new ideas!' Williston,
The Uniform Partnership Act, With Some Remarks on Other Uniform Commercial Laws,
63 U. Pa. L. Rev. 196, 207-08 (1915) '(emphasis deleted).
144. "[T~he only general thing which this draft is based on, as to the question of theory,
is really in a sense positive negation of the proposition that you can regard a partnership
as a separate legal person. I am quite willing to agree with Professor Williston, however,
that we have regarded a partnership as an entity in a great many instances . . . but . . .
the draft has not endowed that entity with a separate legal personality." Remarks of Dr.
William Draper Lewis, commenting on the fifth draft of the Uniform Partnership Act, before
the 21st Annual Conference of the Commissioners on Uniform State Laws, Aug. 23, 1911,
in 36 A.B.X. Rep. 824-25 (1911). The battle between these conflicting theories broke out
in print in the following series of articles (listed chronologically): Crane, The Uniform
Partnership Act-A Criticism, 28 Harv. L. Rev. 762 (1915); Lewis, The Uniform Partnership
Act-A Reply to M4r. Crane's Criticism (pts. 1-2), 29 Harv. L. Rev. 158, 291 (1915) ; Crane,
The Uniform Partnership Act and Legal Persons, 29 Harv. L. Rev. 838 (1916).
FORDHAM LAW REVIEW
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which could be based only on the theory that a partnership is an entity,""
while other provisions are obviously based on the aggregate theory.14 A
partnership under the Internal Revenue Code of 1954 also has a hybrid
nature in that the partnership is not considered a taxable entity, 147 although it is treated as an entity for various tax purposes. 14 8 Other statutes, such as the Bankruptcy Act, 149 and the Uniform Fraudulent Conveyance Act (UFCA)'5 0 purport to treat a partnership as an entity. The
cases often enunciate theories of what a partnership is in order to justify
a particular result, and thus the decisions are not always consistent."'
This inner conflict in the UPA is a basic problem that must be faced in
8 2
drafting many provisions of the partnership agreement.
Regardless of the confusion as to the nature of the partnership arrangement, it is clear from the UPA that the partners will share equally
in profits and losses unless there is agreement to the contrary."13 They
will be personally liable for the debts of the partnership, 4 will have
145. For example, the partnership may hold title to real property (U.P.A. § 8(3)), and
the partner's interest is a personal property interest in the partnership (id. § 26). Each
has certain limited rights as a tenant-in-partnership in the partnership property (td. § 25),
and a right to participate in management (id. § 24). Assignment of a partner's interest will
not cause a dissolution. Id. § 27. When a partnership is dissolved, it continues until "winding
up." Id. § 30. A partner's undivided assets are distributed first to his individual creditors (id.
§ 40), and partnership creditors have priority as to partnership assets. Id. § 40.
146. For example, a partnership will dissolve on the death or withdrawal of a partner
(id. §§ 29, 31(4)) under general agency principles. Partners are generally liable for the debts
of the partnership. Id. § 15.
147. Int. Rev. Code of 1954, § 701.
148. Id. §§ 703, 706, 707(a).
149. See, e.g., Bankruptcy Act § 5, 11 U.S.C. § 23 (1964). Jacob Weinstein, one of the
drafters of the Chandler Act (Act of June 22, 1938, ch. 575, 52 Stat. 840, as amended, 11
U.S.C. (1964)), said of this section: "A partnership is treated under the Bankruptcy Act as
an entity, i.e., a fictional person, separate and distinct from the partners composing it."
J. Weinstein, The Bankruptcy Law of 1938, at 24 (1938).
150. See Uniform Fraudulent Conveyances Act § 8 [hereinafter cited as U.F.C.A.].
"[The Uniform Law [UFCA] adopts the entity theory of the partnership at least to the
extent of determining whether a transfer of partnership assets is a fraudulent conveyance."
1 G. Glenn, Fraudulent Conveyances and Preferences § 216, at 375-76 (rev. ed. 1940).
151. Compare Darby v. Philadelphia Transp. Co., 73 F. Supp. 522 (P.D. Pa. 1947), with
David v. David, 161 Md. 532, 157 A. 755 (1932). As an example of how confusing the cases
are, Bromberg cites McElhinney v. Belsky, 165 Pa. Super. 546, 69 A.2d 178 (1949), as
supporting the entity concept (A. Bromberg, supra note 59, § 3, at 28 n.4. But see id. § 3
at 23 n.55.) while Rowley cites the same case as supporting the aggregate concept. 1 S.
Rowley, supra note 71, § 1.3, at 23 n.69. The sad thing is that both of these authorities are
possibly correct.
152. See part IV infra.
153. U.P.A. § 18(a).
154. Partners are jointly and severally liable for "everything chargeable to the partnership under sections 13 [partner's wrongful act] and 14 [partner's breach of trust]," but
"jointly for all other debts and obligations of the partnership . . . ." Id. § 15.
19711
REAL ESTATE EQUITY INVESTMENTS
rather broad authority to bind the partnership within the apparent scope
of its business, 55 and will have equal rights as to the management of the
partnership business. 56
It is also clear that the partnership may hold title to real property in
its name 5 7 and, since there is no provision in the LUPA equivalent to
section 13 of the ULPA (which sheds doubt on the ability of a limited
partner to have a lien on the partnership assets),' 58 it would seem that a
partnership, absent fraud, could mortgage its assets to one of its partners. 5 9 The UFCA 60 and the Bankruptcy Act, in both of which the
entity aspects of the partnership relationship predominate,' 0 ' make the
conveyance or transfer (including the mortgage)1 02 of partnership property or the incurrence of partnership debt to a partner fraudulent as to
creditors, if the partnership is or will thereby be rendered insolvent.lc In
determining when a partnership is insolvent for the purposes of the
UFCA and the fraudulent conveyances section of the Bankruptcy Act,
the value of the separate assets of each general partner in excess of the
amount needed to meet claims of his separate creditors is added to the
assets of the partnership. 64 Since the assets of most institutional investors probably will be sufficient to satisfy the debts of the institution's
creditors and the partnership creditors, it would seem doubtful that loans
to the partnership by the institutional general partner, and any mortgages
given by the partnership as security, would be fraudulent as to creditors.
While it would seem, therefore, that a mortgage of partnership property
held by a partner would be a valid mortgage, the practical benefits of the
mortgage are reduced by the following: (a) The partner, being generally
liable for all the debts of the partnership, would not seem to obtain any
significant advantage vis-&-vis other partnership creditors in being able
to foreclose a mortgage, since the proceeds thereof would be subject to
155. Id. § 9.
156. Id. §§ 18(e), 24.
157. Id. § 8(3).
158. See discussion of section 13 of the ULPA in part II B supra.
159. See 1 S. Rowley, supra note 71, § 40(b); 68 CJ.S. Partnership § 104 (1950).
160. The UFCA was originally approved by the National Conference of Commissoners on
Uniform State Laws and the American Bar Association in 1918. It is now the law in
twenty-five jurisdictions, including New York, California, Pennsylvania, Michigan, Mifassachusetts and New Jersey. UFCA, 7 Uniform Laws Ann. 423 (Master ed. 1970). The law was
drafted for the National Conference of Commissioners on Uniform State Laws by Dean
William Draper Lewis (see id. at 424), who was primarily responsible for the UPA.
161. See notes 149 & 150 supra.
162. See U.F.C.A. § 1; Bankruptcy Act § 1(30), 11 U.S.C. § 1(30) (1964).
163. See U.F.C.A. § 8; Bankruptcy Act § 67(d)(4), 11 US.C. § 107(d)(4) (1964).
164. See U.F.CA. § 2(2); Bankruptcy Act § 67f(d)(1)(d), 11 U.S.C. § 107(d)(1)(d)
(1964).
FORDHAM LAW REVIEW
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claims of all the creditors of the partnership;165 and (b) section 40(b)
of the UPA provides that partnership liabilities owing to individual
partners, other than for capital and profits, are second in rank of priority 16 in distribution of partnership assets after dissolution of the
partnership. 7 Thus, it would seem that on dissolution no payments may
be received by a partner on any obligation of the partnership, secured
or unsecured, until all the creditors of the partnership have been paid,"0 8
but such obligations and any security therefor, if not fraudulent, would
165. Where real estate values are depressed, however, it would seem advantageous to the
institution to pay the partnership debts, foreclose its mortgage and hold onto the real
estate.
166. This may significantly affect the application of the dual priority rule of UPA
section 40(i) which, with respect to a partner's separate property, gives separate creditors of
an insolvent partner priority over creditors of the partnership. See A. Bromberg, supra note
59, § 93(e). While the reason for the subordination of the partner's claim as creditor In
section 40(b) is not entirely clear, Professor Bromberg speculates it is "that partners' claims
against their firms are often not, in fact, neatly classified into debt, capital contributions and
profits. And even if they were, the books might easily be juggled to convert one into another." Id. § 93(e), at 550. If this theory is correct, there should be no reason to subordinate
claims held by partners as mortgagees of the partnership, inasmuch as the mortgage would
be of record.
167. See Eardley v. Simmons, 8 Utah 2d 159, 330 P.2d 122 (1958). Section 40 states
that its rules shall be observed "subject to any agreement to the contrary." In addition to
appropriate language in the partnership agreement, it might be argued that the mortgage itself
might constitute such an "agreement to the contrary." It would seem, however, that the
drafters of the UPA probably intended this language to refer only to agreements affecting
rights among the partners, and not rights affecting third parties unless they are parties to
such an agreement--especially since the provision has been interpreted as having been
written to protect creditors (see Price v. Slawter, 209 Cal. App. 2d 608, 26 Cal. Rptr. 227
(Dist. Ct. App. 1962)) and since it applies to settling accounts "between partners."
168. For an early enunciation of this somewhat contradictory rule, see Waterman v.
Hunt, 2 R.I. 298 (1852):
"So the firm may, in good faith and for a valuable consideration, give a note to one of the
partners ....
"[They may [also] make a valid mortgage to secure its payment.
"But if [the mortgagee] has retained the notes and mortgage until the company had gone
into bankruptcy, he could not be permitted to enforce them against the assets of the company, to the exclusion of the company creditors, or pari passu with them. Being himself
liable to these creditors he could make no claim until they were paid." Id. at 303-04 (dictum)
(emphasis deleted).
Professor Rowley expresses this rule as follows: "Firm property may be mortgaged to
one partner and the mortgage is not invalid because of the relationship, although such fact
may tend to bear upon the question whether the mortgage was fraudulent. Such mortgage
in inferior to the rights of firm creditors." 1 S. Rowley, supra note 71, § 40(b), at 764
(footnotes omitted). However, it is not entirely clear whether "such mortgage" in the last
sentence of this quotation refers to any mortgage from a partnership to a partner, or only
to a partnership mortgage which is fraudulent. See also 68 C.J.S. Partnership § 104 (1950).
1971]
REAL ESTATE EQUITY INVESTMENTS
613
appear valid and enforceable without subordination to partnership creditors before dissolution. Bankruptcy, of course, would constitute a dissolution of the partnership.6 9 On the other hand, it might be argued that
since the mortgage would normally create a property right in the mortgagee, leaving the mortgagor with an equity of redemption, 170 section 40
was meant to refer only to distribution of the equity of the partnership
over and above mortgages, and not to the rights of a holder of a valid
mortgage--notwithstanding the fact that he is a partner.' Whether the
argument would be successful is not clear.
Thus, in the case of a general partnership, the institutional investor
can exercise the control over the operation of the partnership it would
be unable to exercise as a limited partner. In most cases it could, subject
to possible priorities of creditors of the partnership, hold partnership
assets as security for loans which would be questionable under the
ULPA, while continuing to avoid the double taxation problems inherent
in a corporate structure. To obtain these advantages, the institutional
and limited liability, and
investor must give up important protection
72
wrestle with the complexities of the UPA.1
169. U.P.A. § 31(5).
170. See generally 4 American Law of Property §§ 16.6-.12 (A.J. Casner ed. 1952).
171. The following are some of the arguments which might be advanced:
1. If it is determined that the mortgage to a partner is valid and cannot be set aside as
being fraudulent, the only assets the partnership has to which section 40(b) of the UPA
can apply would seem to be the value of its property over and above valid liens.
2. Both the UFCA and the UPA were written primarily by Dean William Draper Lewis.
In the earlier draft of the UPA, Dean Lewis had inserted a fraudulent conveyances clause
similar to the one presently in section 8 of the UFCA. This was section 21(3) in the seventh
draft of the UPA. See Crane, The Uniform Partnership Act-A Criticism, 28 Harv. L. Rev.
762, 766 n.87 (1915). Crane notes, without approval, that the section was placed in the
UFCA rather than the UPA because "it was felt that it pertained rather to another branch
of the law and was out of place in the partnership code." Id. at 776. Thus, while it is clear
that Dean Lewis knew and clearly adverted to the problem of fraudulent conveyances (see
Lewis, The Uniform Partnership Act-A Reply to Mr. Crane's Criticism, 29 Harv. L. Rev.
291, 296-98 (1916)), if section 40 is given a broad interpretation, it would subordinate debts
owed to partners to the claims of other creditors and severely restrict the scope of section 8
of the UFCA. It is not clear that this was intended.
3. It is conceptually difficult to understand how a mortgage can be both valid and subordinate to general creditors even in a limited area, or what sense it makes to permit a
partner to foreclose a day before bankruptcy but, if he has not foreclosed, to subordinate
him to general creditors the day after. Whether or not these arguments have merit, it would
appear that the reason for subordination in section 40(b) "appears not to have been
scrutinized carefully." See A. Bromberg, supra note 59, § 93(e). A reasoned clarification of
the statute, at least with respect to mortgages held by partners on partnership property,
appears to be in order.
172. See part V infra.
614
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C.
[Vol. 39
Direct Versus Subsidiary Investment
Equity investments of institutional lenders have been made either directly in the name of the institution or by a subsidiary corporation of
the investor. 73 State laws regulating institutional investors often restrict
the number and type of subsidiaries such investor may have and the
purposes for which they may be organized. 4 If the investment through
a subsidiary is permitted, it may nevertheless create significant tax
problems. On the other hand, it may help solve some of the other problems that have disturbed institutional investors in this area.
1. Tax Considerations
In deciding whether to participate in a real estate equity investment
directly or through a subsidiary, a key consideration for the institutional
investor is the effective rate at which net income from the venture will
be taxed in the hands of the subsidiary, as compared to the effective tax
rate in the hands of the institutional investor if received directly. The
subsidiary will normally pay tax on net income at the full corporate rate
of forty-eight percent." 5 If the institutional investor is also in a fortyeight percent tax bracket, the tax considerations are fairly neutral since
the institutional investor usually can have the subsidiary's profits re173. It has often been said that a corporation may not be a partner because a corporation's directors may not share or delegate their management functions. The UPA, however,
defines "partnership" as an association of two or more "persons" and defines persons to Indude corporations. See U.P.A. §§ 2, 6. The UPA provision, however, may not In itself constitute an authorization for corporations to join partnerships. See, e.g., 1935 N.Y. Op. Attly
Gen. 230. In New York, such authority is found in Bus. Corp. Law § 202(a)(15) (McKinney
1963), subject, inter alia, to anything contrary in the certificate of incorporation. Other
states may not be so explicit. See H. Ballantine, Corporations § 87 (rev. ed. 1946). In
these states, shareholders' approval, or a specific provision in the certificate of Incorporation
authorizing membership in partnerships, often is sufficient to permit such membership. See
generally ABA Committee on Partnerships & Unincorporated Business Associations, May a
Corporation Be a Partner?, 17 Bus. Law. 514 (1962).
As explained by Professor Ballantine, even if there is no authority for a corporation to
enter into a partnership, the corporation may still incur liability of a partner to third
parties. It also has been said that a corporation could enter a partnership If It had solo
management of the business, or if the enterprise were denominated a "joint venture", rather
than a partnership. Id. But see note 64 supra.
174. For example, with respect to insurance companies, see N.Y. Ins. Law §§ 46(a),
81(9) (McKinney Supp. 1970).
175. Int. Rev. Code of 1954, § 11. While in the past the use of a subsidiary created an
additional surtax exemption on the first $25,000 of taxable income (id. § 11(d)), the Tax
Reform Act of 1969 provides for the gradual elimination of this benefit over the period
1970-1974, with its complete elimination thereafter. Int. Rev. Code of 1954, §§ 1561, 1562,
1564. A life insurance company and its real estate subsidiaries will be entitled to two
surtax exemptions. Id. § 1563(b) (2) (D).
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REAL ESTATE EQUITY INVESTMENTS
mitted to it on a tax-free basis. 76 However, where the institutional investor is taxed at a lower effective tax rate than the subsidiary would be,
use of the subsidiary may result in additional tax burdens. Many types of
institutional lenders, such as life insurance companies, 1t 7 mutual savings
banks, 7 ' real estate investment trusts,179 and qualified pension trusts,18°
either do not pay tax on their net investment income or are taxed at an
effective rate less than the full corporate rate of forty-eight percent.
Thus use of a fully taxable subsidiary can prove disadvantageous from
a tax viewpoint.
If business and other non-tax reasons nevertheless dictate the use of
a subsidiary, the taxable income of the subsidiary can be reduced by the
judicious use of a mixture of both debt and stock investment, rather than
stock investment only. The chief concern here is insuring that the debt
will be considered as bona fide debt for tax purposes, so that the interest
paid by the subsidiary will be deductible from its income. 16 ' Because of
the close relationship of the parties, it is essential that the arrangement
reflect as many indicia of true debt as possible. Assuming this is done,
there is the additional question of how much debt can be issued without
the arrangement being subject to attack on "thin capitalization" grounds.
In the past, it has been impossible to say with complete certainty what
ratio of debt to equity was immune from Internal Revenue Service
attack, since the cases in this area generally have considered thin capitalization as only one of a number of factors to be considered.'8 However,
a debt-equity ratio of five-to-one or even ten-to-one (exclusive of mortgages made by the partuership) probably was fairly safe, assuming the
investment otherwise had the preponderant characteristics of debt.
This already cloudy area has been further beclouded, at least temporarily, by the Tax Reform Act of 1969, which, in adding section 3 85iea
to the Internal Revenue Code, gave broad authority to the Treasury
Department to issue regulations setting forth factors which are to be
taken into account in determining whether debt or stock is *present.
Section 385 reads as follows:
Treatment of certain interests in corporations as stock or indebtedness.
(a) Authority to prescribe regulations.-The Secretary or his delegate is authorized
176.
See text accompanying notes 191-95 infra.
177. Int. Rev. Code of 1954, §§ 801-20.
178. Id. §§ 591-96.
179. Id. §§ 856-58.
18o. Id. §§ 401(a), 501(a).
181. Id. § 163.
182.
In Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1969), the
court listed sixteen criteria for judging whether an investment is debt or equity.
183. Act of Dec. 30, 1969, Pub. L. No. 91-172, § 415(a), 83 Stat. 487, 613-14.
FORDHAM LAW REVIEW
[Vol. 39
to prescribe such regulations as may be necessary or appropriate to determine
whether an interest in a corporation is to be treated for purposes of this title as
stock or indebtedness.
(b) Factors.-The regulations prescribed under this section shall set forth factors
which are to be taken into account in determining with respect to a particular factual
situation whether a debtor-creditor relationship exists or a corporation-shareholder
relationship exists. The factors so set forth in the regulations may include among
other factors:
(1) whether there is a written unconditional promise to pay on demand or on a
specified date a sum certain in money in return for an adequate consideration in
money or money's worth, and to pay a fixed rate of interest,
(2) whether there is subordination to or preference over any indebtedness of the
corporation,
(3) the ratio of debt to equity of the corporation,
(4) whether there is convertibility into the stock of the corporation, and
(5) the relationship between holdings of stock in the corporation and holdings
of the interest in question. 184
Since the ratio of debt to equity is one of the factors specifically listed,
presumably the regulations will lay down some guidelines in this area.
One commentator has taken the rather Draconian view that the regulations should establish a two-to-one debt-equity ratio as the norm. 185 Until
the proposed regulations are issued, reliance on existing law would appear
justified. While there is nothing in section 385 to prevent the regulations
from being given retroactive effect, in the interests of fairness the regulations under section 385 should be given prospective effect only.'
The filing of a consolidated return by the institutional investor, if that
course is open to it, can be used to nullify the tax disadvantage in utilizing a subsidiary in lieu of direct investment. 1 7 The consolidated return
approach is particularly important if the subsidiary has net operating
losses which can be offset against the parent's income. In the early years
of the subsidiary, this is quite likely to be the case because of the combined effect of accelerated depreciation (if used) ,'8 high start-up expenses,. and relatively low rental income. Even with the availability of
a three-year carryback and a five-year carryover for net operating
losses,'18 the tax benefit of the loss deduction could be deferred or even
lost entirely in the absence of a consolidation of returns.
Certain types of institutional investors, including life insurance com184. Int. Rev. Code of 1954, § 385.
185. Bordman, Section 385: Classification of Certain Interests as Stock or IndebtednessProposed Regulations, 23 Tax Exec. 391, 410-12 (1970).
186.
187.
188.
189.
See Int. Rev. Code of 1954, § 7805(b).
See id. §§ 1501-05.
Id. 9 167(b).
Id. § 172.
1971]
REAL ESTATE EQUITY INVESTMENTS
panies, real estate investment trusts, and qualified pension trusts, do not
have the consolidated return approach available to them.9 0
Where the subsidiary does have profits, the institutional investor parent, if a taxable entity, will wish to have profits remitted without payment of an additional income tax at its level. The filing of consolidated
returns avoids the problem, since intercorporate dividends among the
members of the affiliated group are not taxable.' Even if consolidated
returns are not filed, the intercorporate dividends normally will qualify
for an eighty-five percent dividends received deduction which can be
increased to a hundred percent deduction at the election of the parent. 10 2
Generally, the only significant price for making the hundred percent
election is the foregoing of multiple surtax exemptions, 1 3 which are of
short-lived value. 4 Profits which have not been remitted as dividends
ordinarily can be recovered by the parent at some time in the future by
means of a tax-free liquidation.-"5
The life insurance company institutional investor, because of its
unique tax treatment under the Code,' finds that the use of a real estate
subsidiary presents additional problems which other institutional investors do not have. As noted above, the consolidated return approach is
not open to the life insurance company, so that net operating losses of the
subsidiary cannot be used to offset the parent's income.
Also, where the subsidiary has profits which are taxed and then remitted to the parent as dividends, even with the election of the hundred percent dividends received deduction, there normally will be an effect on the
tax incurred by the life insurance company parent. This result occurs
because all investment income (including tax-exempt income) is taken
into account in a complex statutory formula which determines what
portion of the investment income is deemed needed to satisfy obligations
to policyholders ("policyholders' share") and is therefore non-taxable,
and what portion is free investment income ("company's share") subject
to tax.19 7 Briefly, the higher the portfolio rate of return, the greater the
policyholders' share. Accordingly, if the tax-free dividends on the subsidiary's stock are at a lower rate than the general portfolio rate, they
190. Id. § 1504(b).
191. Treas. Reg. § 1.1502-14(a)(1) (1966).
192. Int. Rev. Code of 1954, § 243.
193. Id. § 243(b) (3) (C) (v).
194.
See note 175 supra.
195. Int. Rev. Code of 1954, § 332.
196. Id. §9 801-20.
197.
Id.
99804(b)(1)(A), 804(a)(2)(A)(iii); see United States v. Atlas Life Ins. Co.,
381 U.S. 233 (1965).
FORDHAM LAW REVIEW
[Vol. 39
will depress the overall rate and therefore increase the company's share
of investment income. Conversely, if they are at a higher rate than the
rate on the balance of the portfolio, the company's share of investment
will be decreased.
A further complication arises from the fact that the amount of the life
insurance company's assets is a component of the statutory formula and
that stocks (and real property) are valued at fair market value for this
purpose whereas all other property is valued at adjusted basis." 8 Generally the larger the amount of assets, the higher the company's tax. Since
a partnership interest is personal property, 1 9 it is valued at adjusted
basis if held by the insurer directly. However, if the interest is held by a
subsidiary, presumably the fair market value of the partnership interest
(which may be greater or less than its adjusted basis) will be reflected
in the value of the subsidiary's stock. The requirement that the subsidiary's stock be valued at fair market value also raises the possibility
that the Internal Revenue Service will not accept whatever valuation of
the subsidiary's stock the life insurer uses.
Use of a real estate subsidiary by the institutional investor also has a
potential for trouble under section 482 of the Code, which gives the Internal Revenue Service broad power to allocate income, deductions, and
the like between two corporations owned or controlled by the same interests. Since the investment personnel of the parent institutional investor
normally can be expected to render services for the real estate subsidiary
as well, it is important that adequate records be kept of the time spent
on subsidiary matters, and that transactions between parent and subsidiary be maintained on an arm's length basis to the extent feasible.
Despite the numerous tax problems and lack of countervailing tax
benefits which use of a subsidiary may entail, other business reasons
have resulted in the widespread use of subsidiaries by institutional investors.
2. Non-tax Considerations
There are several non-tax considerations that may cause the institutional investor to organize a real estate subsidiary or subsidiaries for
equity investments.
First, there are the risks imposed by the general liability feature of
a partnership and the ability of one partner to bind the other. 00 As a real
estate subsidiary's assets increase and the number of joint ventures
multiply, the assets of the subsidiary exposed to liability increase and the
198.
199.
200.
int. Rev. Code of 1954, § 805 (b) (2)'(B) & (b) (4).
See U.P.A. § 26.
See part IV C infra.
REAL ESTATE EQUITY INVESTMENTS
1971]
protection afforded by the use of a corporate subsidiary decreases. Thus
real limited liability, such as that of a limited partner or stockholder, can
be achieved in the subsidiary approach only by creating a separate corporate subsidiary for each joint venture. The use of any number of subsidiaries, however, is difficult from a logistic point of view"' and may
increase the risk of attack on the corporate entity (as discussed below).
Even when the institution has only one subsidiary for equity investment,
and even when this subsidiary has become a substantial corporation in
its own right, institutional investment officers still feel more secure
knowing that most of the depositors' or policyholders' money is safe from
significant liabilities, however remote.
Second, real estate equity interests have not been a traditional subject
for investment by institutions, which still consider such joint ventures
somewhat outside their life style and prefer to retain at least a measure
of anonymity. There is a justifiable feeling that the association of the
large institutional investor's name with a piece of property encourages
litigious plaintiffs, produces higher costs, and sometimes causes involuntary involvement in day-to-day operations. There is a fear that even if
the action of the partner-developer does not create liability, the institution might be put in a position where its name or reputation could suffer
due to acts over which it has no control.
Third, where the institution has become wed to the limited partnership
approach, it can make its equity investment through a subsidiary as
limited partner without running afoul of the ULPA proscription against
a limited partner's taking or holding security.20 2 The control problem
would not be resolved,20 3 however, making the subsidiary-limited partnership approach advantageous only where the institution wishes to
protect the assets of a substantial subsidiary.
Fourth, the institution's mortgage would be protected against subordination to partnership creditors under section 40 of the UPA.
All the desired results of the use of a subsidiary are contingent on the
courts respecting the corporate separateness of the subsidiary. The
general rule that a corporation is an entity separate and apart from its
stockholders and that the stockholders are not liable for the debts of the
corporation 0 4 is, of course, clear. However, in several areas courts have
occasionally "pierced the corporate veil."
201. For example, Board of Directors' meetings must be held, books must be kept, tax
returns filed etc. This can become extremely expensive and time consuming as the number of
subsidiaries grow.
202.
See part IlB 2 supra.
203. Id.
204. See generally N. Lattin, Corporations, ch. 2 (1959); Berle, The Theory of Enterprise Entity, 47 Colum. L. Rev. 343 (1947).
FORDHAM LAW REVIEW
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Generally, disregard of the corporate entity has occurred in situations
where the corporation was severely undercapitalized and the creditors
were not aware of it;205 where the shareholders held themselves out as
being obligated for the corporate debts; 20 6 where there was a commingling of assets and a failure to operate the corporation as a corporation,
resulting in a general disregard of the corporate entity by the shareholders, directors and officers;207 when the corporation is a "mere instrumentality" of its parent and the recognition of the corporate entity would
work a fraud or injustice;20 8 and in other areas where the court found
that public policy or considerations of fraud should preclude recognition
of the corporate entity. 0
The danger to the institution would apparently occur if a court were
to hold it liable for the debts of the subsidiary, or hold that the subsidiary's debts to the institution were subordinate to the rights of creditors
of the subsidiary, either because (i) the subsidiary was undercapitalized;
(ii) the corporate entity was disregarded by the institution; or (iii) the
subsidiary was a "mere instrumentality" of the parent.
As to undercapitalization, the test is not the total amount of capital
but whether the capital is reasonably adequate to meet the corporation's
prospective liabilities.2 10 The danger would seem to be greatest when the
corporation is formed, since the capital in the subsidiary generally will
grow as the value of its assets increase, especially where one or just a
few subsidiaries are used for many equity investments. In any case, if
the capital of the subsidiary bears a reasonable relation to its expected
debts, as would normally be the case in the institutional subsidiary
situation, it would seem that there should be little ground for disregarding the corporate entity on the basis of under-capitalization.
If the institution is careful about maintaining the distinction between
parent and subsidiary, 21 1 there should be no piercing of the veil on that
205. Compare Arnold v. Phillips, 117 F.2d 497 (5th Cir.), cert. denied, 313 U.S. 583
(1941), with Bartle v. Home Owners Coop. Inc., 309 N.Y. 103, 127 N.E.2d 832 (1955).
See generally Annot., 63 A.L.R.2d 1051 (1959).
206. See Weisser v. Mursam Shoe Corp., 127 F.2d 344 (2d Cir. 1942).
207. Compare Sisco-Hamilton Co. v. Lennon, 240 F.2d 68 (7th Cir. 1957), with B]erkey
v. Third Ave. Ry., 244 N.Y. 84, 155 N.E. 58 (1926).
208. See generally 1 W. Fletcher, Cyclopedia of Corporations § 41.1 (rev. ed. 1963).
209. See United States v. Milwaukee Refrig. Transit Co., 142 F. 247, 255 (C.C.E.D. Wis.
1905), where the court said: "[A] corporation will be looked upon as a legal entity as a
general rule, and until sufficient reason to the c6ntrary appears; but when the notion of
legal entity is used to defeat public convenience, justify wrong, protect fraud or defend
crime, the law will regard the corporation as an association of persons."
210. H. Ballantine, Corporations § 129 (rev. ed. 1946).
211. See Associates Dev. Corp. v. Air Control Prod., Inc., 392 S.W.2d 542, 544-45 (Tex.
Civ. App. 1965), where the court adopted guidelines for parent-subsidiary relationships.
19711
REAL ESTATE EQUITY INVESTMENTS
account. As to the subsidiary being a "mere instrumentality" of the
parent, this basis for piercing the corporate veil seems to have been applied in the situation where the parent has manipulated the subsidiary for
its own purposes in a manner which 'would work a fraud or injustice
upon creditors,2 '2 and normally should not create a problem in the institutional equity subsidiary situation.
Nevertheless, the institution should take every precaution to avoid
any of the danger areas associated with piercing the corporate veil, for
the failure to do this could have serious consequences.
III. THE COMMTMENT
A joint venture usually begins with a commitment given by a lending
institution or its mortgage banking correspondent to a developer. This
beginning may be a fleeting provision in the mortgage commitment providing for a joint venture, or there may be a separate formal agreement
to create and invest in a joint venture, with the terms of the partnership
agreement annexed to or forming a part of the agreement.
A. Mortgage Commitment Provision
Traditionally, commitments, and especially mortgage commitments,
are "bankable," i.e., banking institutions will lend construction money in
reliance on them, considering themselves thereby reasonably assured of
a take-out. This is not to say the commitment must be unconditional.
Regulated by federal statutes, national banks may make loans having
maturities of no more than thirty-six months to finance the construction
of industrial or commercial buildings, where there is a valid and binding
agreement entered into by a financially responsible lender to advance
the full amount of the bank's loan upon completion of the buildings. 1 3
The statute does not define the meaning of "valid and binding."
Certainly, standard mortgage commitments are conditioned upon completion of the premises satisfactory title, solvency of the borrower, and
perhaps acquisition of certain permits and certificates-all of which
212.
In Taylor v. Standard Gas & Elec. Co., 306 U.S. 307, 322 (1939), the Court stated
that the instrumentality rule "is not, properly speaking, a rule, but a convenient way of
designating the application in particular circumstances of the broader equitable principle
that the doctrine of corporate entity, recognized generally and for most purposes, will not
be regarded when so to do would work fraud or injustice." Professor Ballantine explained:
"The term 'instrumentality' is a word of too uncertain meaning to express any legal test.
All corporations are used as business instrumentalities ....
A fter all, it comes down to a question either of agency or of good faith, honesty and
fairness in the use of the corporate privilege for legitimate ends." H. Ballantine, Corporations
§ 136 (rev. ed. 1946).
213. 12 U.S.C. § 371 (1964).
FORDHAM LAW REVIEW
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must usually be met by a date certain. In some events, a bank or its
subsidiary could take over and proceed to eliminate the failure of performance. However, a broad condition to mortgage disbursement that
the developer and the lending institution have entered into a joint venture
agreement, in form and substance satisfactory to the lending institution,
is generally too uncertain for a construction lender. Attaching the form
of joint venture agreement helps. Also, spelling out the conditions for
entering into the joint venture by the institutional lender, making them
similar to the conditions for making the mortgage loan, is helpful. The
conditions for entering into the venture cannot, however, be entirely met
by the performance of the conditions required for making the mortgage
loan. Title matters such as junior liens and certain conditions not affectbut imposing civil or criminal sanctions on an owner are
ing the lien
2 14
examples.
B. Separate Commitment
Many banks making a construction loan prefer elimination from the
mortgage commitment of all reference to a joint venture and, for various
reasons, the institutional lender may agree. In that event, there will be
a separate contract or commitment for a joint venture. Usually the construction lender need not rely on the separate agreement, because the
proceeds of the permanent loan will be sufficient to pay off his construction loan. If the loan is insufficient, greater certainty in the contract or
commitment, including the form of joint venture agreement, would give
better bankabillty.
On the other hand, in separating the loan commitment from the joint
venture agreement, the lending institution has perhaps helped solve one
problem while creating another. If the joint venture is not a condition to
the making or purchasing of the permanent mortgage loan, can the institution be assured of obtaining the joint venture interest? Most joint
ventures are partnerships in form, and thus the interest to be acquired
constitutes personal property. According to the general rule, there is no
specific performance of an agreement to enter into a partnership, 2 16 although in special circumstances some courts have enforced such an
agreement. 1 6
214. The equity commitment will often contain a condition that there are no llens on
the property. While the mortgagees interest is unaffected by liens junior to the mortgage,
the owner is still subject to them. Similarly, the institution as owner Is concerned about
building code violations imposing liability on the owner, though as mortgagee It may not
be liable.
215. Rabinowitz v. Borish, 43 F. Supp. 413 (D.N.J. 1942); Maxa v. Jones, 148 Md.
459, 129 A. 652 (1925); 11 S. Williston, Contracts § 1442 (3d ed. W. Jaeger 1968); See
1 S. Rowley, supra note 71, § 48.38.
216. For example, in Snodgrass v. Stubbs, 54 A.2d 338 (Md. Ct. App. 1947), after
1971]
REAL ESTATE EQUITY INVESTMENTS
A possible solution to this problem is to have the mortgage commitment provide that the loan shall be callable if a joint venture is not entered into within a stated period after the institution acquires the
mortgage investment. If such a provision were of sufficient certainty,
reasonableness and clarity, it should be enforceable.
17
If the interest to be acquired is that of tenant in common, and if all
the usual standards of completeness of contract are met, there seems to
be no reason why an agreement with the developer should not be speci-
fically enforceable
18
Of course, the breach of an agreement to enter into or convey an interest in a partnership should constitute grounds for a damage action. 1 In
addition to recovering actual losses incurred,22-' prospective profits might
be recovered if they can be ascertained and are not speculative.2' Properforming his part of the agreement, the plaintiff was granted specific performance and
the court ordered that his interest in the real and personal property of the business be
conveyed to him. Additionally, in Jones v. Styles, 268 Ala. 595, 109 So. 2d 713 (1959),
the court, in overruling a demurer to the complaint, held that it could order "the execution
of partnership articles" to form a partnership for an existing insurance business "if necessary
to invest a partner with the legal rights for which he had entered into the partnership,
although after the articles are executed, the parties cannot be compelled to act under them."
Id. at 597-98, 109 So. 2d at 715. See also Whitworth v. Harris, 40 Miss. 483 (1866) ; Favero v.
Wynacht, 371 P.2d 858 (Mont. 1962); 81 C.J.S. Specific Performance §§ 1S, 81 (1953).
217. See Hasbrouck v. Van Winkle, 261 App. Div. 679, 27 N.YS.2d 72 (3d Dep't 1941),
aff'd, 289 N.Y. 595, 43 N.E.2d 723 (1942), where the mortgagors covenants to build a
house on certain property within ten years (and in default thereof, to pay the mortgagee
$1,000) were enforceable. The court held that the mortgagee could foreclose upon breach
of those covenants. It would seem to follow that covenants to enter into a joint venture
within a specified time or, in default thereof, to pay the entire debt, should be enforceable
at the mortgagee's option-especially since the debt is supported by independent consideration. Cf. M Land Corp. v. Halstead, 184 Misc. 679, 56 N.YS. 682 (Sup. Ct. 1945),
where the court said that "[a] foreclosure may be based upon the 'non-performance of
any act' required by the mortgage." See also 1 C. Wiltsie, A Treatise on the Law and
Practice of Real Property Mortgage Foreclosure § 64, at 126 (Sth ed. 1939), stating that
a "mortgage may provide for foreclosure for the whole debt or for maturity of the whole
indebtedness upon the breach of any condition or of a single covenant or condition."
For the validity of acceleration clauses generally, see 1 G. Glenn, Mortgages § S1 (1943);
9 G. Thompson, Real Property § 4744 (1958).
218. Bauermeister v. Sullivan, 87 Ind. App. 628, 160 N.E. lOS (1928); 11 S.Williston,
Contracts § 1418A (3d ed. W. Jaeger 1968); Restatement of Contracts § 360 (1932); 49
Am. Jur. Specific Performance §§ 62, 63 (1943).
219. Manny v. Burke, 174 App. Div. 654, 160 N.YS. 879 (3d Dep't 1916); Hill v.
Palmer, 56 Wis. 123, 14 N.W. 20 (1882). See also cases cited in 21 A.L.R. 22 (1922); 58
A.L.R. 621 (1929); 168 A.L.R. 1088 (1947); 70 A.L.R.2d 618 (1960).
220. Braxdale v. Bange, 166 Cal. App. 2d 399, 333 P.2d 420 (Dist. Ct. App. 1958); see
Barry v. Handlin, 189 Cal. 465, 207 P. 902 (1922); Skinner v. Tinker, 34 Barb. 333 (N.Y.
Sup. Ct. 1861); Webster v. Beau, 77 Wash. 444, 137 P. 1013 (1914). See also 40 Am. Jur.
Partnership § 500 (1942); 68 CJ.S. Partnership § 11(b) (1950); 5 A Corbin, Contracts
§ 1031 (1964).
221. Ramsay v. Meade, 37 Colo. 465, 86 P. 1018 (1906); Webster v. Bean, 77 Wash.
FORDHAM LAW REVIEW
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spective profits, however, often cannot be proved or are not allowed. In
this situation, the measure of damages should be the excess in value of
the thing to be conveyed (partnership interest) over the price. 222 Just
what evidence would determine this is unclear.
C. Usury Considerations
The absence of a requirement for a joint venture in the mortgage commitment, or the absence of any provision making the loan callable unless
the institution obtains an interest in the joint venture, helps to solve
another problem: usury.
The typical joint venture interest obtained by an institutional investor
at the time of making a mortgage loan is purchased for what the parties
deem a fair price, determined according to prospects at the time of
contracting. Nevertheless, unless the transaction is exempt under local
law by reason of corporate, large loan or business purpose exclusions, a
usury problem may exist. Anything of value obtained by a lender in con-
nection with the making of a loan, either directly or through a subsidiary,
may be considered interest. In one case, the lender received manure from
a mortgaged hotel, in addition to interest at seven percent. The manure
was held to be interest, making the loan usurious. 23 Accordingly, if the
joint venture interest is a condition of making the mortgage loan and is
worth more than is paid for it, it can be argued that this additional value
is consideration for the mortgage loan. Fortunately, most states 224 (including New York,22 5 but apparently not Texas 228 ) permit any additional
consideration received to be spread over the life of the loan, as variously
444, 137 P. 1013 (1914) (dictum). See also 40 Am. Jur. Partnership § 500 (1942). Cf.
10 Encyclopedia of New York Law 230, citing Skinner v. Tinker, 34 Barb. 333 (N.Y. Sup.
Ct. 1861).
222.
Gilbert v. Grubel, 82 Kan. 476, 108 P. 798 (1910); Lawless v. Melone, 350 Mass.
440, 214 N.E.2d 881 (1966); cf. 5 A. Corbin, Contracts § 1098 (1964), dealing with
executory contracts to convey land.
223. Vilas v. McBride, 62 Hun. 324, 17 N.Y.S. 171 (Sup. Ct. 1891), afl'd mem., 136 N.Y.
634, 32 N.E. 1014 (1892). See generally cases cited in 95 A.L.R. 1231 (1935).
224. "[Tlhe general rule [is]that in testing a contract for usury 'the entire period of
the loan must be taken into consideration.'" Hershman, Usury and "New Look" In Real
Estate Financing, 4 Real Prop. Probate & Trust J. 315, 316 (1969) (footnote omitted),
225. Reisman v. William Hartman & Son, Inc., 51 Misc. 2d 393, 273 N.Y.S.2d 295 (Sup.
Ct. 1966), citing Feldman v. Kings Highway Say. Bank, 278 App. Div. 589, 102 N.Y.S.2d
306 (2d Dep't), afi'd, 303 N.Y. 675, 102 N.E.2d 835 (1951).
226. There are no cases construing the present corporate usury statute, which limits Interest to I percent per month. Tex. Rev. Civ. Stat. Ann. art. 1302-2.09 (Supp. 1970). However, when the statutory limit was 10 percent per annum, a line of cases held that interest
charges could not be spread over the term of the loan. Shropshire v. Commerce Farm
Credit Co., 120 Tex. 400, 30 S.W.2d 282 (1930), motion for rehearing overruled, 39 S.W.2d
11 (Tex.), cert. denied, 284 U.S. 675 (1931); Commerce Trust Co. v. Ramp, 138 S.W,2d
531 (Tex. Comm'n App. 1940).
1971]
REAL ESTATE EQUITY INVESTMENTS
defined.227 Thus, for example, for a loan of $1,000,000 for ten years at
eight percent interest in a state with a ten percent usury limit, the usual
rule, absent amortization, would be that a $200,000 bonus in the form
of a joint venture interest, if not in cash, would not create usury. 21
Amortization, prepayment, or calling privileges, if exercised, could reduce
the permissible additional consideration. Assuming in this example that a
joint venture interest was acquired for $100,000, usury would not normally
be a problem unless the joint venture interest (1) was required, expressly
or impliedly, as a condition to making a loan; and (2) was worth in excess
of $300,000, reflecting a gross undervaluation. 0
If the joint venture is freely entered into and not required in the mortgage commitment, and if the developer is free to sell the interest to others
after he obtains his mortgage commitment or even his loan, it is difficult
to find that a deficiency in the sales price for the venture interest would
constitute a bonus for making the loan, and thus usury.so However, a
gross undervaluation of the venture interest (e.g., the sale of a $100,000
interest for $100) might shock a court into finding some element of
227. In Manchester Realty Co. v. Kanehl, 130 Conn. 552, 36 A.2d 114 (1944), Chief
justice Maitbie multiplied the highest legal interest rate (12 percent per annum) by the
loan amount actually advanced, and further multiplied this by the term of the loan, thereby
finding the maximum the lender could charge. Apparently, the lender could receive up to
this amount at any time under any plan of payment. In Green Ridge Corp. v. South Jersey
Mortgage Co., 211 So. 2d 70 (Fla. Dist. Ct. App.), cert. denied, 219 So. 2d 702 (Fla. 1968),
the court held that interest and bonuses should be apportioned "over the period commencing
with the date of closing and ending with either the date of the [foreclosure] decree or
the original maturity date, whichever is prior in time." 211 So. 2d at 72. As the court
stated: "The test of usury followed in Florida is not based upon the contingencies inherent
in a transaction, but upon what actually develops." Id. at 71. This rule has now been
changed by statute so that charges are spread over the stated term of the loan. Law of
July 2, 1970, ch. 70-331, § 1, [19701 Fla. Laws Extraord. Sess. 969. See also Pennsylvania
Mut. Life Ins. Co. v. Orr, 217 Iowa 1022, 252 N.W. 745 (1934); 91 CJ.S. Usury § 42
(1955).
228. With the usury rate of 10 percent per annum, over the term of the loan as much
as $1,000,000 in interest could be charged (10 percent of the loan of $1,000,000, multiplied
by the term of 10 years). Thus, over the term, interest at 8 percent ($800,000) plus a
$200,000 bonus is allowable.
229. The difference between the fair value (over $300,000) and the price paid ($10D,000)
is considered additional interest (over $200,000) charged for making the loam This additional
interest, when added to the eight percent (or $800,000 over the term), exceeds the amount
allowed ($1,000,000).
230. In Memorial Gardens of Wasatch, Inc. v. Everett Vinson & Associates, 264 F.2d
282 (10th Cir. 1959), under a reversed fact pattern, the borrower alleged that the loan to
him was usurious because of the simultaneous land purchase agreement. The court found
no usury, holding that the parties intended a land purchase transaction rather than a loan.
"The loan was incidental to the sale. In fact, there was no firm agreement to borrow or to
loan any sum. [The borrower] was free to arrange for development capital In any way he
wished." Id. at 285.
FORDHAM LAW REVIEW
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fraud, coercion, or illegal side agreement, constituting the $99,900 a
bonus and hence interest.
If the joint venture is not a condition to the loan, however, the developer may elect not to offer an equity interest to the lender because
a third party makes a more attractive offer. If the venture is considered
essential by the lender, it might make the venture a requirement of the
mortgage, with documentation that will satisfy the construction lender,
and take other steps to avoid usury. This is not always a great problem. If the price is fair (as documented by appraisals), if the loan
interest rate is sufficiently less than the usury rate, and if the loan amount
is far greater than the joint venture contribution (as it usually is), there
is a large margin for error. With presumptions against usury, the risk
can be minimal, but as the difference between the loan rate and usury rate
narrows, the risk increases. The danger is not that a bonus truly exists,
but that years later, when the development becomes a great financial
success, a judge or jury trying the facts might apply hindsight and find a
far higher value for the equity interest than that originally agreed to by
the parties. The fact that the mortgage financing gives the equity investment the benefit of leverage can help lead to this result.
In some instances, lenders have sought to be sure of acquiring the
desired equity interest by obtaining, at the time of giving a land loan
commitment or permanent loan commitment, an option to buy a part
interest in the developer's land at a favorable price. By separate agreement, the institution agrees not to exercise its option if a satisfactory
joint venture is entered into. This technique has been used to make a joint
venture commitment practicable where there was insufficient planning of
land use, and consequently insufficient knowledge of the amounts involved. Unfortunately, this technique has several drawbacks.
The option, unlike a contract to enter into a joint venture, would
seem to have some value-which might be considered additional interest.
option is unenforceMoreover, at least one case has held that such an
231
able as being merely further security for the debt.
Finally, if the institution is permitted to determine whether it will
enter the joint venture after the project has been completed and its value
demonstrated, the excess of the value over purchase price may be ordinary taxable income to the institution-a fee paid for making the
loan. 32
Title Insurance
Mortgagees customarily require that title insurance be provided by the
borrower in mortgage transactions, or by the seller in sale-leaseback
D.
231.
232.
Barr v. Granaban, 255 Wis. 192, 38 N.W.2d 705 (1949).
int. Rev. Code of 1954, § 61(a); Treas. Reg. § 1.61-1(a) (1957).
19711
REAL ESTATE EQUITY INVESTMENTS
transactions. Joint ventures create a new problem. Assume a $10,000,000
mortgage on property worth $11,000,000, and the acquisition of fifty percent of the equity for $500,000. There normally would be a $10 million
mortgagee policy and an $11 million owner's policy. Also, the latter
would normally run to the partnership, where title is held in the partnership name. Two problems result.
(1) Notwithstanding reduced rates for simultaneously ordered insurance, developers resent paying all or even half of its cost. The institution, however, is likely in its commitments to require both policies (i)
in order to protect its equity investment, which will become more valuable over the years as a result of amortization payments on the mortgage; and (ii) because the standard form of title policy provides in
effect that when the title company pays the institutional mortgagee, it
is subrogated to the mortgagee's rights against the mortgagor,= which
is the institutional mortgagee or its wholly owned subsidiary. 4 This
difficulty could be alleviated if the title company could cause a separate
owner's policy of $5,500,000 to be issued to the institution (not the partnership) or its subsidiary, limiting the title insurer's subrogation rights
under the mortgagee policy to the developer's interest in the partnership.
The policy would expressly state that despite the personal property exception in some title policies t 5 and the personal property nature of the
institution's partnership interest, such interest is insured as though it
were real property. However, thus far such insurance, with its conceptual
233. "10. Subrogation Upon Payment or Settlement. Whenever the Company shall have
settled a claim under this policy, all right of subrogation shall vest in the Company unaffected by any act of the insured claimant .... The Company shall be subrogated to and
be entitled to all rights and remedies which such insured chaiant would have had against
any person or property in respect to such claim had this policy not been issued, and if
requested by the Company, such insured claimant shall transfer to the Company all rights
and remedies which such insured claimant would have had against any person or property
in respect to such claim had this policy not been issued, and if requested by the Company,
such insured claimant shall transfer to the Company all rights and remedies against any
person or property necessary in order to perfect such right of subrogation and shall permit
the Company to use the name of such insured claimant in any transaction or litigation
involving such rights or remedies. If the payment does not cover the loss of such insured
claimant, the Company shall be subrogated to such rights and remedies in the proportion
which said payment bears to the amount of said loss, but such subrogation shall be in
subordination to the insured mortgage." American Land Title Association Standard Loan
Policy, Conditions and Stipulations, para. 10 (1970).
234. In the event of a title defect, the mortgagee's title policy will protect the institution's mortgage investment but not its equity investment, since the institution is in the
position of lender rather than owner. If covenants of title are made, or if there is personal
liability, the title company may be subrogated to the rights of the mortgagee, and may
sue the institution or its subsidiary, qua owner, on its or their covenants.
235. See, e.g, New York Board of Title Underwriters, Title Insurance Policy (Form
10DE, rev. eff. 7/1/69), in which Schedule B(7) excludes "[t]itle to any personal property,
whether the same be attached to or used in connection with said premises or otherwise."
FORDHAM LAW REVIEW
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difficulties, has not been generally available. Even if a title company
could issue such a policy-covering by its terms the aforesaid problems
raised by subrogation provisions and the personal property nature of
partnership interests-appropriate provisions in the partnership or venture agreement would also be required. It should be made clear that the
institutional partner is entitled to recover the entire proceeds of the insurance, and that the exercise of subrogation rights by a title insurer
against the developer's interest creates no right in the developer against
the institution or its interest.
(2) In a policy to a partnership, knowledge of either partner may be
attributed to the insured partnership. The standard form of title policy
normally provides that the title insurer is not responsible for title defects
known to the insured but not on the record and unknown to the title company.23 6 Thus, if a separate policy cannot be issued to the institution
and the partnership is the insured, the developer's knowledge of the defect may preclude recovery under the policy. Title insurers have thus far
been unwilling, and in some states may be unable, 3 7 to issue nonimputation insurance. Thus, if the partnership is to hold title to the real property, imputation is the risk the institutional investor may have to take.
In considering the problems of title insurance, title to the real estate
held by the venturers as tenants in common may be preferred to title
held by the partnership. As a tenant in common, the institution can obtain its own policy covering its own undivided interest, without any fear
of imputation of the developer's knowledge.
IV.
OPERATION OF THE PROPERTY: THE "JOINT
VENTURE" AGREEMENT
When the terms of the commitment have been complied with, the institution or its subsidiary becomes obligated to make its equity contribution-normally under a joint venture agreement, the terms of which were
agreed to at the time the commitment was executed.233 Often the joint
236.
The American Land Title Association Standard Loan Policy, 1970 form, expressly
excludes from its coverage: "3. Defects, liens, encumbrances, adverse claims, or other
matters (a) created, suffered, assumed or agreed to by the insured claimant; (b) not known
to the Company and not shown by the public records but known to the Insured claimant
either at Date of Policy or at the date such claimant acquired an estate or interest Insured
by this policy or acquired the insured mortgage and not disclosed in writing by the insured
claimant to the Company prior to the date such insured claimant became an insured hereunder . . . ." Id., Schedule of Exclusions from Coverage (TO 1691 PNTI (S-70)).
237. In some states, the forms of title policies are fixed by statute and cannot be
readily changed. See Tex. Ins. Code Ann. art. 9.07 (1963).
238. See part Ill B supra.
19711
REAL ESTATE EQUITY INVESTMENTS
venture agreement is attached to the commitment as an exhibit. Its negotiation is usually extremely difficult and consumes a great deal of time,
probably because both parties realize that the project's ultimate success
and the safety of the investment may hinge on the outcome of these negotiations&3 9
A. Title to the Real Estate
Prior to the adoption of the UPA, a partnership, being a collection of
individuals, could not ordinarily hold title to real property.2 -11 On this
point, however, the entity aspects of the UPA became predominant, and
section 8(3) of that Act permits title to real estate to be held in the name
of the partnership. In states that have not adopted the UPA, the real
property must be owned directly by the partners, normally as tenants in
common. This technique may also be employed where the UPA is in
effect, if it should be considered desirable.
A tenancy in common is, of course, a method of co-ownership of property under which each of the owners has an undivided interest in the entire property.2 41 Either owner may convey, mortgage, or otherwise transfer his interest to third parties, unless precluded by restrictions in his
deed or by agreement with his tenant in common. Upon the death of a
tenant in common, his undivided interest will normally pass to his heirs
or devisees.' 42 Absent an enforceable agreement to the contrary, the tenants normally have a right to "partition" (i.e., ask a court to divide) the
property, and where an equitable division in kind is unfeasible, the court
will normally sell the property and divide the proceeds between the parties in accordance with their respective undivided interests. 4 Either
party may be a purchaser at such sale. 4 The partition procedure is not
239. No attempt is being made to cover all the provisions which may be found in a
typical real estate joint venture agreement. Only basic problems and provisions that have
caused the most difficulty in negotiations are discussed. Among other things, the compensation
(if any) and the duties of the manager should also be spelled out in some detail; the agreement should contain minimum requirements for insurance, including workmen's compensation, comprehensive general liability, all risk builder's, crime, and other such insurance as
may be required by the institutional investor; provisions should be written covering accounting and distributions, including requirements for periodic audits by independent certified public accountants; and, where appropriate, there should be inserted provisions
giving the institution a preferential right to purchase an interest in surrounding land if
such land is acquired by the developer.
240. See F. Mechem, supra note 71, § 153.
241. See generally 2 American Law of Property § 6-5 (A.J. Casner ed. 1952).
242. Id. § 6.10.
243. Id. §§ 6.21, 6.26.
244. See 68 CJ.S. Partition § 184(a) (1950).
FORDHAM LAW REVIEW
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disadvantageous to the institutional lender, since presumably the institualways be in a position to protect its interest on a sale
tional lender will
24
of the property. 5
If a tenancy in common is employed, an agreement will be executed
providing for the operation and maintenance of the property. The parties
will generally have the same authority and powers with respect to such
operation as they would in a partnership that has title to the real property. Whether the operating agreement between tenants in common makes
the parties partners for the operation of the property will, as discussed
above,24 6 depend on what the agreement says. It would seem that in most
cases, if the institutional lender has the controls it normally wishes to
agreement will probably create the legal relationship of parthave, the
247
ners.
Where title to the real estate is held in the name of the partnership,
the partners would each have an interest in the partnership 248 which is an
interest in personal property. 249 Additionally, a partner has certain limited rights in specific partnership property, known as his tenancy in partnership, 250 and a "property" right to participate in management. 251 Where
the partnership assets are interests in real property, the partner's aggregate rights, at least in New York, have been determined to be equivalent
to an interest in real estate for the purposes of sections of the law regulat22
ing institutional investments, which permit acquisition of real property.
B. Control and Management; Remedies on Default
1. Control and Management
Once the decision has been made to utilize a general partnership vehicle, the attorney drafting the partnership agreement is faced with a
conflict in objectives. The institutional investor, to protect its investment
and guard against possible liabilities, desires to exercise control over the
245. Special tax considerations relating to tenants in common as distinguished from
partners are discussed in part IV D infra.
246. See part II A 2 supra.
247. Id.
248. UPA. § 24(2).
249. Id. § 26.
250. Id. §§ 24(1), 29(1).
251. Id. §§ 18(e), 24(3).
252. For example, the New York Insurance Department, ina letter to an Insurer, stated:
"This isto advise you that an investment in an interest in a partnership, joint venture or
trust, where the partnership, joint venture or trustee is the record holder of real property
or an interest therein, constitutes an investment in real property or an Interest thereunder
.
under Section 81(7) (h) [of the New York Insurance Law] ....
1971]
REAL ESTATE EQUITY INVESTMENTS
operation of the partnership. Between the desire and the exercise, however, falls the shadow,253 inasmuch as the institutional lender normally
has neither the facilities, personnel, time nor expertise to handle the dayto-day operation of the property. Once an investment has been made, the
personnel of the institutional lender will normally become involved in the
negotiations of other investments, and with each new investment the overall "housekeeping" required of existing investments becomes that much
greater. It is nevertheless clear that the institution must be prepared to
do more than was required when its main "housekeeping" function involved the mortgagor's monthly payments of interest and principal.
A typical agreement compromising between detailed involvement in
day-to-day operations and abdication of all control functions might require the consent of both partners for all "major decisions." "Major decisions" could be defined to include, inter alia, sale, mortgaging, approval
of the annual budget, and initiation of new construction programs.2 1
253. Cf. T.S. Eliot The Hollow Men, in The Complete Poems and Plays 1909-19S0, at
56,59 (1952).
254. A provision on major decisions might provide, inter alia:
"No act shall be taken, sum expended, decision made or obligation incurred by the Venture, Manager, or any Venturer with respect to a matter within the scope of any of the
major decisions (hereinafter called "Major Decisions") as enumerated below, unless such
of the Major Decisions have been Approved by the Venturers [this phrase normally means
approval of all the partners]. The Major Decisions shall include:
"(1) Acquisition of any land or interest therein;
"(2) Financing of the Venture, including but not limited to the financing of the acquisition of the Property, interim and permanent financing of the Improvements and financing
operations of the Venture;
"(3) Sale, or other transfer, or mortgaging or the placing or suffering of any other encumbrance on any of the Property or the Improvements or any part or parts thereof;
"(4) Lease or other arrangement involving space in any Improvements if such lease or
other arrangement... ;
"(5) Terminating or modifying any lease of other arrangement involving space in any
of the Improvements... ;
"(6) Construction of any Improvements or the making of any Capital Improvements,
repairs, alterations or changes... ;
"(7) Selecting or varying depredation and accounting methods, changing the fiscal year
of the Venture and making other decisions with respect to treatment of various transactions
for bookkeeping or tax purposes, consistent with the other provisions of this Agreement;
"(8) Approval of all construction and architectural contracts and all architectural plans,
specifications and drawings prior to the construction of any improvements contemplated
thereby;
"(9) Varying or changing any portion of the insurance program required by Company
in accordance with Article MI hereof;
"(10) Determining whether or not distributions should be made to the Venturers, except
hereof;
as set forth in Section
hereof;
"(11) Approving each Budget pursuant to Section
"(12) Making any expenditure or incurring any obligation by or of the Venture in-
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[Vol. 39
Under this type of arrangement, the partnership can work successfully
as long as both partners are in agreement. When they disagree, a method
is provided-a buy-sell agreement or right of first refusal-to end the
relationship.2 55
The day-to-day management of the property is then entrusted to a
"manager" (often the developer), who is responsible for its operation,
but who frequently is permitted to employ a managing agent to do the
work. The manager may expend money within the approved budget allocations, and he is normally given a certain amount of discretion beyond
authorized budget expenses. He must bring all other expenses and all
matters within the area of major decisions to the partners for their determination.
When one of the partners is the manager, and even when a third party
is the manager, self-dealing can be a major problem. If the gardening,
management, rent collection, repairs, guard service, etc. can be delegated
at exorbitant fees to corporations owned or controlled by the manager,
even the most successful property may have little profit left for distribution to the partners. If the self-dealing managing agent is a partner, such
self-dealing would appear to be in violation of the partner's fiduciary
duties to his co-partner, 256 and a default under the agreement. Where
the self-dealing managing agent is not a partner, the overreaching by the
for any transaction or group of similar transactions exvolving a sum in excess of $
cept for expenditures made and obligations incurred pursuant to and specifically set forth
in a Budget theretofore Approved by the Venturers; making any expenditure or incurring
any obligation which when added to any other expenditure for the Fiscal Year of the
9; or making any expenditure or incurring any
Venture exceeds the Budget by
obligation which falls into any category or categories of expenditures which in the opinion
of Company and its counsel is required by law to have the prior approval of Company or Its
Board of Directors;
"(13) Determination of the maximum and minimum working capital requirements of
the Venture; or
"(14) Any other decision or action which by any provision of this Agreement is required
to be Approved by the Venturers or which materially affects the Venture or the assets or
operations thereof."
255. See discussion of the buy-sell arrangement in part IV E infra.
256. See U.P.A. § 21(1), which makes a partner accountable to the partnership as a
fiduciary for "any profits derived by him without the consent of the other partners from
any transaction connected with the formation, conduct, or liquidation of the partnership
or from any use by him of its property." See Meinhard v. Salmon, 249 N.Y. 458, 164 N.E.
545 (1928). In this connection, where appropriate the agreement should make It clear that
the partners may enter into other real estate transactions without accountability to their
partners. Such a clause might provide:
"Nothing in this agreement shall be deemed to restrict in any way the freedom of any
party hereto to conduct any other business or activity whatsoever (including the acquisition,
development and exploitation of real property) without any accountability to the venture
or any party hereto, even if such business or activity competes with the business of the
venture."
1971]
REAL ESTATE EQUITY INVESTMENTS
633
manager can nevertheless amount to a breach of the manager's duty of
loyalty to the partnership, 257 for which an action would be available.2 s
However, problems of proof in the area of self-dealing make is advisable
that protection also come from the language of the agreement itself and
from careful supervision.
It would probably be unacceptable to any developer-manager to have
the agreement prohibit his dealing with companies he owns or controls.
Such dealings may in fact be a benefit to the project, since the manager
would be more familiar with the work of related organizations and probably would have greater control over and confidence in these firms. The
problem can be avoided by a simple provision that the manager shall not
enter into agreements for goods or services with any related party unless
the contract is approved by all the partners.- 9 Then reasonable contracts
can be approved by the institution, and unreasonable ones rejected.
As an alternative, the agreement might provide that the cost of all services and supplies shall not exceed what is reasonable for the area where
the property is located. Admittedly, this is a rather indefinite standard.
A proven violation of the requirement, however, might subject the manager to certain liabilities for damages, and this should serve as an inhibition on overreaching. As an additional precaution, it may be advisable
to require that the manager periodically furnish to the partners a list of
related corporations with whom the partnership is dealing. These precautions, however, may in themselves be insufficient, since what is "reasonable" may be the rates set by local organizations based upon routine small
257. See Restatement (Second) of Agency §§ 387-88 (1958).
258. Id. §§ 399-409.
259. A "related parties" clause might provide, inter alia:
"The Manager or any Venturer shall not enter into any contract, agreement, lease, or other
arrangement for the furnishing to or by the Venture of goods, services or space with any
party or entity related to or affiliated with the Manager or any Venturer or with respect
to which the Manager or any Venturer or party or entity related to or affiliated with the
Manager or any Venturer has any direct or indirect ownership or control unless such contract, agreement, or arrangement has been approved by the Venturers. By way of illustration and not as a limitation on the scope of the phrase 'related or affiliated with', for the
purposes of this section, the following shall be considered related to or affiliated with the
Manager or any Venturer:
1. Any corporation, partnership, association or other entity (hereinafter in this Section
referred to as 'Entity') owned in whole or in part by the Manager or any Venturer;
2. Any holder of more than ten (10) percent of the issued and outstanding shares of,
or any holder of more than a 10% interest in the Manager, any Venturer, or any Entity
owned in part by the Manager or any Venturer;
3. Any Entity in which any officer, director, employee, partner or shareholder (or member of the family of any such officer, director, employee, partner or shareholder) of the
Manager, any Venturer or any Entity owned in whole or in part by the Manager or any
Venturer, has a direct or indirect interest or relationship, which interest or relationship
includes, but is not limited to, a partner, employee, agent or stockholder interest or relationship:'
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transactions. Such rates may be appropriate for small transactions but
often they are excessive in larger ones-where rates are frequently negotiated downward. Thus, the institutional lender might be advised to
attempt to negotiate the provision giving it the right to approve contracts.
Control over who will serve as manager or managing agent is often
considered by institutional investors important to the protection of their
investment. Such control can protect the institution not only where a suspected overreaching is difficult to prove, but also during the hiatus between the time major disagreement2 0 between the partners arises and the
actual disposition of the property.
A typical agreement which contains such protection might state that
the institution consents to the developer serving as manager or managing
agent, but that the institution may at any time withdraw its consent. To
do this, it will furnish the developer with a list of three managing agents
experienced in managing property of the type owned by the partnership
in the area where the property is located, from which list the developer
may select a replacement manager or managing agent.
Some developers argue that the right to change managers or managing
agents should be limited to what might be termed discharges for cause.
This, of course, raises problems and delays associated with proving cause,
problems which the provision is supposedly inserted to avoid. Other developers desire an equal right to furnish such a list to the institution, and
to require discharge of any replacement manager or managing agent.
Such a provision has been negotiated into the agreement on occasion, but
misuse of these rights could create "turnstile management" to the disadvantage of all parties. The provision has offended some developers-one of whom dubbed it the "Huey, Louie and Dewey" clause because of
the suggestion that the institution furnish the names of three managing
agents. Nevertheless, many developers have made it clear that they have
no objection to the clause. Their stated reasons are (1) their confidence
that the job they will do as manager or managing agent will be more than
satisfactory to their institutional partner; (2) their certainty that if one
partner is dissatisfied with management, the partnership would not work
and thus management should be placed in the hands of a third party;
and (3) their belief that because of the potential costs involved in obtaining outside management, the institutional partner will not exercise its
rights frivolously.
2. Remedies on Default
On default by one of the parties, there
are normally several courses of
21
action open to the nondefaulting party.
260.
261.
See part IV E infra.
Some agreements will provide for arbitration of disputes under the agreement, or
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REAL ESTATE EQUITY INVESTMENTS
First, he may invoke any of the terms of the partnership agreement
providing for a termination of the partnership. This usually is in the form
of the "buy-sell" agreement, 212 a right which is normally made available to
either party with or without default. In proper cases, he might obtain
immediate injunctive relief against a defaulting partner to prevent or stop
acts which violate the agreement or are prejudicial to the rights of the
other parties2 e
Second, if the default constitutes a breach of a partner's duty to the
partnership, it may be possible for the nondefaulting partner to bring an
action for an accounting under section 22 (d) of the UPA. Prior to the
UPA, an accounting would normally occur in connection with dissolution
of the partnership. 64 Under the UPA this is still generally the rule, but
section 22 of the UPA now provides, inter alia, that a partner is entitled
to an accounting when the "circumstances render it just and reasonable." 6 5 It is in the course of the accounting that adjustment will be
made to make the nondefaulting partner whole. Thus, if the developer
defaults in providing services to the partnership as manager, it may be
that damages can be recovered after an accounting without dissolution. 6 61
Of course, any party may force a dissolution of the partnership pursuant
to or in contravention of the partnership agreement.
Third, if the default constitutes a breach of an obligation or duty of
one partner to another, as distinct from an obligation of one partner to
the partnership, the nondefaulting partner may bring an action directly
against the defaulting partner for damages or, where appropriate, restitution or specific performance.267 For example, if the developer does not
perform the promised management services to the partnership, an action
in damages by the nondefaulting partner against the defaulting partner
for arbitration of whether a default has occurred. Because of what is considered the informality in application of judicial standards in arbitration, and because of limited appellate
recourse (see generally AL Domke, The Law and Practice of Commercial Arbitration 312
(1968)), many institutional investors would prefer to limit arbitration to what they consider
"arbitrable" issues, such as whether "cause" exists for the discharge of a managing agent,
or what the value is of a particular piece of real estate.
262. See part IV E infra.
263. See generally 2 S. Rowley, supra note 71, § 48.41.
264. See generally 2 S. Rowley, supra note 51, § 47.1. In some circumstances, however,
accounting has been permitted without dissolution. See, e.g., Miller v. Freeman, 111 Ga.
654, 36 S.. 961 (1900).
265. U.P.A. § 22(d). In the Comment to this section, the drafters make it dear that
even under the UPA a formal accounting normally may be had only on dissolution. Since
each partner has access to the partnership books, formal accountings are not usually necessary. This Comment recognizes, however, that "at particular times and under particular
circumstances" an accounting may be had when there is no dissolution.
266. See A. Bromberg, supra note 89, §§ 65(f), 69, 70.
267. Id. § 69.
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generally would not lie.28 8 However, if the developer borrows money from
the institution and defaults in payment, the institutional partner may recover that money in a suit directly against the developer-partner."' In
addition, if the real property is held by the partners in their individual
capacity as tenants in common, an action in tort would seem to lie between the partners for damages to the property of one of them.270 It
would seem that in the area of remedies for default, the entity aspects of
the partnership predominate, and therefore it is necessary to determine
in each situation whether the obligation in default is an obligation to the
partnership or an obligation to a partner.
C. Operating Losses, Liabilities, and Profits
When an institutional lender makes a mortgage loan, its greatest risk
is the loss of its investment. The remedy of foreclosure, coupled with
sound appraisals and the cushion provided by statutory loan-to-value
ratios, 71 makes it unlikely that the institution would lose a substantial
portion of its mortgage investment even if the project is an economic
failure for the developers. When the risk is small so is the gain, and as a
result the institutional lender normally has received a fixed return over a
long period of time. 2 With equity investments, the institution has an
opportunity to share in the profits of the venture and to protect its depositors, policyholders, and stockholders against the risks of inflation;
but with equity investments comes the risk of exposure to liabilities.
1. Operating Losses
There are actually some developers who request the institution to agree
to put up, in addition to its initial capital contribution, all additional
funds that may be necessary over the years to keep the partnership in
business. Obviously, even if the business people in the institution wish to
comply with such a request, they cannot do so without the approval of
the institution's board of directors.2 73 Even its board of directors prob268.
269.
1951).
270.
271.
Id.; see, e.g., Miller v. Freeman, 111 Ga. 654, 36 S.E. 961, 962 (1900).
See Chung Gee v. Quan Wing, 103 Cal. App. 2d 19, 229 P.2d 50 (Dist. Ct. App.
See Smith v. Hensley, 354 S.W.2d 744 (Ky. 1962).
See note 35 supra.
272. Due to the pressures of inflation during the past few years, institutional lenders
have shortened the term of loans by approximately ten years, without reducing the period
required for complete amortization of the loan. This leaves a certain amount of unpaid
principal outstanding at the end of the term. This "balloon," as it is often called, can be
refinanced at a then current interest rate, thus helping to reduce the effects of Inflation.
Interest rates, however, have not always reflected inflation trends, and this procedure could
backfire on the institution. Contingent interest might help, but usury statutes restrict the
effectiveness of this type of inflation hedge.
273. For example, no investment or loan may be made in New York by any domestic
life insurance company unless it has been authorized by the hoard of directors, or by a
1971]
REAL ESTATE EQUITY INVESTMENTS
ably could not bind future boards 274 to such an approach to equity investments 5 On the other hand, when the institution owns property directly
in its own name, it would normally incur obligations-e.g., the obligation
to pay taxes, make repairs required by law, or make mortgage payments
-even where income is insufficient to meet these expenses. Similarly, an
institution as joint venture partner should be able to agree to put up its
share of additional funds necessary to meet these expenses. This would
seem to be as far as the institution could go. Beyond this, the partners
would have to decide at the time whether they wish to put more money
in, borrow additional funds or dispose of the property at a loss.
2. Liabilities
As a general partner, the institution is liable for the acts of its partner
within the scope, or apparent scope, of the venture. - 0 The partnership
agreement, if carefully drawn, should clearly limit the actual scope of
each partner's authority. It is, therefore, "apparent" scope that can cause
the problems. Just as an "apparent" horse may not be a horse, - 7 so "apparent" scope or "apparent" authority may not be the real scope of the
venture, or the real authority conferred upon a partner. Rather, it is what
a third party dealing with the venture or a partner would think is the
scope of the venture or the authority of the partner.27 8 Fortunately, the
committee thereof charged with the duty of supervising or making such investment or loan.
N.Y. Ins. Law § 78(1) (McKinney Supp. 1970).
274. A board of directors may not delegate its powers of supervision and management,
since this may be considered a surrender of its functions. An agreement to invest undetermined amounts of additional funds at any time in the future would seem to encroach upon
the power of future boards. In a similar context, Ballantine suggests that "[iln making
arrangements in the nature of a partnership to which a corporation is a party, as in drafting
management contracts, it would be well to preserve the ultimate authority of the directors
and to make the contract subject to termination upon reasonable notice for cause, and even
at the option of the board of directors after a limited time, in order to avoid undue
delegation or abdication of control by the directors over the management of the corporate
business." H. Ballantine, Corporations § 87 (rev. ed. 1946) (footnote omitted). See also id.
§ 48.
275. Of course, when a board of directors authorizes a corporation to become a partner.
it is, in effect, authorizing it to become liable to third parties for losses. As between the
partners, however, the UPA specifies that each partner is required to contribute towards
the losses in proportion to his share of the profits, unless there is agreement to the contrary.
U.P.A. § 10(a). The institutional investor normally will want such an agreement.
276. See U.P.A. § 9; IS. Rowley, supra note 71, § 9.1, at 247-48.
277. The foregoing words are a paraphrase of part of Professor Austin W. Scott's remarks
to his classes in connection with "constructive" trusts.
278. In dealing with the partner or venture, a reasonable man might determine the
scope of the partner's apparent authority by looking to the partnership agreement, the
course of business of the particular partnership, or the course of business of similar partnerships in the locality. A. Bromberg, supra note 59, § 49, at 276.
FORDHAM LAW REVIEW
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larger the transaction, the more unreasonable it would seem for a person
to assume without further proof that the transaction is within the scope
of the venture or the authority of the partner. Thus, while a person might
be justified in assuming that the managing partner of the XYZ Joint Venture had authority to order a steel safe for the rental office, he would be
less justified in assuming the managing partner could purchase, on behalf
of the venture, the steel company and its assets. The picture becomes less
clear when the fact situation is somewhere between these extremes. In
any case, the standards are vague and the risk of liability, however remote,
is always present.2 1 9 If the developer has substantial assets, the institution
may attempt to achieve some protection with an indemnification from the
developer for his acts outside and in contravention of the partnership
agreement. While this is helpful, it cannot eliminate the problem. Thus,
the institution must frequently and thoroughly check on the operation of
the venture in order to protect its interest and guard against liability.
3. Profit
Of course, the object of the venture is to make a profit. Inasmuch as
the interests of the partners might not always be consistent with respect
to when there should be a distribution of the expected profit, such distributions would normally constitute a "major decision," requiring approval
of all the venturers. Distributions normally are made in accordance with
the respective interests of the parties. However, when an institution puts
up all or most of the cash required, the agreement will often provide for
a cash flow distribution preference in favor of the institution, until all or
substantially all of the initial or subsequent capital contributions of the
venturers are repaid. Subsequently, the distributions will be made in accordance with the respective interests of the parties.
D. Some Tax Considerations
1. Existence of a Partnership for Tax Purposes
The tax definition of a partnership is an extremely broad one: "[T]he
term 'partnership' includes a syndicate, group, pool, joint venture, or
other unincorporated organization through or by means of which any
business, financial operation, or venture is carried on, and which is not,
within the meaning of this title, a corporation or a trust or estate. 2 ' 8
279. Occasionally the institution is asked to enter an existing partnership. This often
occurs when the parties wish to retain the advantage of being the first user of property
already in use (see discussion in part IV D 5 infra). If the institution agrees to enter an
existing partnership, it will be liable "for all the obligations of the partnership arising
before [its] admission," but such liability will be "satisfied only out of partnership property." U.P.A. § 17. It therefore would seem that, unless there are countervailing business
reasons for doing so, entering existing partnerships may not ordinarily be desirable.
280.
Int. Rev. Code of 1954, § 761(a). See also id. § 7701(a)(2).
REAL ESTATE EQUITY INVESTMENTS
In addition to a formal partnership organized under the UPA or the
ULPA, the definition is broad enough to encompass real estate "joint ventures," as well as tenancies in common of commercial real estate. While
some courts have found that a tenancy in common of real estate does not
create a partnership for tax purposes, the cases generally have involved
individuals who acquired the real property through inheritance and
rented it out 1 Since there was no business motive in the acquisition, the
courts were reluctant to find a partnership for tax purposes. However, in
the type of arrangement being discussed, the developer and the institutional investor have a clear business purpose to operate the property for
profit and to share in its gains and losses. Where the real property is held
as a tenancy in common and no formal partnership is established, the
parties customarily will have an "operating agreement," which in virtually all respects is the same as a partnership agreement. The Treasury
Regulations recognize that such an arrangement can constitute a partnership: "Tenants in common, however, may be partners if they actively
carry on a trade, business, financial operation, or venture and divide the
profits thereof. For example, a partnership exists if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent." - The last clause above seems
to indicate that if the property were leased on a net basis, partnership
treatment could be avoided. However, the parties normally will not operate the property on such a basis. For the purposes of the following discussion, it will be assumed that a partnership for tax purposes does exist.
2. Contributions to the Partnership
Ordinarily, no gain or loss is recognized when an individual contributes
property in exchange for an interest in the partnership. 21 Frequently the
developer has held the land on which the commercial building is or will
be built for some time, and there has been considerable appreciation in
value. By contributing the property to the partnership rather than selling
a portion of it to the institutional investor, the developer can defer the
gain on the appreciation until a later time. When appreciated property is
contributed to the partnership by the developer, the institutional investor
normally will want the partnership agreement to provide for a special
allocation of the gain upon ultimate disposition of the property. If the
property is depreciable, a special allocation of depreciation may also be
desirable to reflect the difference between the depreciable basis of the
281. Lulu Lung Powell, 26 CCH Tax Ct. ]Mfem. 161 (1967); Lena Hahn, 22 T.C. 212,
petition for review dismissed, 216 F.2d 954 (8th Cir. 1954); In re Estate of Appleby, 41
B.T.A. 18 (1940), aff'd, 123 F.2d 700 (2d Cir. 1941).
282. Treas. Reg. § 1.761-1(a) (1) (1956).
283.
Int. Rev. Code of 1954, § 721.
FORDHAM LAW REVIEW
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property (carried over from the developer) and its higher fair market
value at the time of contribution.28 4
An alternative approach to the problem is to have a sale of the appreciated property by the partner to the partnership. This may be desirable
if the property is depreciable, e.g., a building, since a sale, while requiring the partner to recognize gain, 2 0 gives the partnership a stepped-up
basis for tax -purposes,28 0 and avoids the need for special allocation provisions for gain and depreciation. While there may be some risk that the
Internal Revenue Service will challenge the sale as a de facto contribution, the Code specifically recognizes that a partner and his partnership
can deal on an arm's length basis, 2 17 and thus a bona fide sale so intended
by the parties should be recognized for tax purposes.2 8
In some cases, the developer may make no capital contribution at all.
He in effect contributes his know-how and skill, and the institutional investor provides all the necessary financing through loans and capital contributions. Where the developer in such a case receives a capital interest
in the partnership, it may be considered compensation for services and
thus ordinary income to him at some time.280 Since the developer is expected to render his services over a substantial period of time, the time
of receipt of such income for tax purposes is difficult to predict. Receipt
of the income probably can be deferred, and perhaps ordinary income
treatment can be avoided altogether, by providing that such capital interest is not transferable, is payable only on liquidation of the partnership,
and only after the institutional investor has first recovered all of its
capital contributions.
3. Effect of Debt on Basis of Partnership Interest
Generally speaking, a partner's initial tax basis for his partnership
interest is equal to the amount of money and the adjusted basis of property he contributes to the partnership. 20° However, a partner's basis is
also increased by his share of partnership liabilities. 201 This is significant
where it is anticipated that losses will occur in the early years of the
project (or where losses do in fact occur at any time), since a partner can
deduct his share of the losses against other income only to the extent that
Id. § 704(c)(2).
Id. § 1002.
Id. § 1012.
Id. § 707(a).
Treas. Reg. § 1.721-1(a) (1956).
Id. § 1.72 1-1(b) (1), (2). See also United States v. Frazell, 335 F.2d 487, rehearing
339 F.2d 885 (5th Cir. 1964), cert. denied, 380 U.S. 961 (1965).
290. Int. Rev. Code of 1954, § 722.
291. Id. § 752(a).
284.
285.
286.
287.
288.
289.
denied,
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REAL ESTATE EQUITY INVESTMENTS
he has a positive basis for his partnership interest.21 2 Since the property
ordinarily will be heavily mortgaged, both the developer (even where he
makes no capital contribution) and the institutional investor should have
a substantial tax basis for their partnership interests. Where a limited
partnership is used, with the developer as general partner and the institutional investor as limited partner, the institutional investor should require that the developer-general partner not be personally liable for the
mortgage loan, for the limited partner gets no step-up in basis if the general partner is personally liable.20 3 Even where a general partnership is
used, it may be advisable either to have both parties personally liable or
to have neither liable, so that both will be assured an increase in basis.
4. Special Allocations for Tax Purposes
Unless the partnership agreement provides otherwise, a partner's share
of the various tax items of income, gain, loss, deduction and credit of the
partnership is determined in accordance with his share of the taxable income or loss of the partnership. 294 The partnership agreement may, however, provide for special allocation of specific items. This will be recognized for income tax purposes, unless the primary goal of the allocation
is the avoidance or evasion of income tax2 The regulations list a number of factors to be considered in determining whether the principal purpose of a special allocation is the avoidance or evasion of income tax:
Whether the partnership or a partner individually has a business purpose for the
allocation; whether the allocation has 'substantial economic effect,' that is, whether
the allocation may actually affect the dollar amount of the partners' shares of the
total partnership income or loss independently of tax consequences; whether related
items of income, gain, loss, deduction, or credit from the same source are subject to
the same allocation; whether the allocation was made without recognition of normal
business factors and only after the amount of the specially allocated item could
reasonably be estimated; the duration of the allocation; and the overall tax consequences of the allocation.2 96
One special allocation already mentioned is an allocation to take account
of contributed property which at the time of contribution has a value in
excess of its basis. 0 7 There may also be other circumstances justifying a
special allocation. For example, the institutional investor, for personal
liability reasons, may not want to enter into the partnership with the developer until the development is virtually completed. Assume that the
institutional investor then contributes fifty percent of the total building
292. Id. § 704(d). If the loss is in excess of such basis, it may be deducted at the end
of any partnership year in which this excess is repaid to the partnership. Id.
293. Treas. Reg. § 1.752-1(c) (1956).
294. Int. Rev. Code of 1954, § 704(b) (1).
295. Id. § 704(b)(2).
296.
Treas. Reg. § 1.704-1(b) (2) (1956). See also Stanley C. Orrisch, 55 T.C. No. 39
(Dec. 7, 1970).
297. Int. Rev. Code of 1954, § 704(c) (2).
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[Vol. 3 9
and land cost in return for a fifty percent partnership interest. During
construction, the developer, as sole owner, ordinarily has an election for
tax purposes to treat certain items (such as real estate taxes and interest)
either as expenses or as additions to basis. 0 8 The developer normally will
wish to expense these items. This means, however, that the institutional
investor will be contributing fifty percent of the total building costs, part
of which have already been written off by the developer. The same may
be true of depreciation deductions if the property is completed and rented
in stages, and the institutional investor does not become a partner until
the final stage is finished. In such a case the institutional investor, to protect its position, may wish the partnership agreement (the terms of which
are agreed to prior to construction) to provide that in no event will its
share of depreciation be less than fifty percent of the total building cost.
Because of the bona fide business reasons for the special allocation, it
should be recognized for tax purposes. Alternatively, the institutional investor may be able to contractually bind the developer to elect to capitalize these items during construction.
5. Depreciation
The Tax Reform Act of 1969 has somewhat reduced the benefits of
accelerated depreciation." 9 Nevertheless, the parties may still wish to use
this method if the property meets the requirement that its "first use"
commence with the taxpayer °0° In this case the partnership is considered
the taxpayer. 0 1 Thus, if the partnership is formed and the property is
transferred to it after the property is put in use, accelerated depreciation
will be lost. There may be a clash of interests if the developer is anxious
for accelerated depreciation, while the institutional investor is unwilling
to form the partnership during the construction period and run the risks
associated with construction. Ordinarily, both partners will have to follow the same method of depreciation for income tax purposes, since the
election of the depreciation method is made by the partnership and is
binding on each of the partners. 0 2 If the parties take title to the property
as tenants in common, however, and then form the partnership and contribute the property to it, they may treat the property for depreciation
purposes (and also for gain or loss purposes) as if it were not partnership property-providedtheir interests in the capital and profits of the
partnership correspond to their undivided interests in the property. 0 9 If
the property is not actually contributed to the partnership, but is merely
298. Id. § 266.
299.
300.
301.
302.
303.
Int. Rev. Code of 1954, §§ 167(j), 1250(a).
Int. Rev. Code of 1954, §§ 167(c) (2), 167(j) (2) (A) (ii), 167(J) (4), (5).
Treas. Reg. § 1.167(c)-1(a) (6) (1956).
Int. Rev. Code of 1954, § 703(b).
Id. § 704(c).
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REAL ESTATE EQUITY INVESTMENTS
used by it, the parties also apparently may treat the property as individually owned for depreciation and gain and loss purposes?04 Since tenants
in common are not obligated to use the same method of depreciation, the
parties in a partnership arrangement flowing from tenancy in common
ownership should have the same right.
E. Dissolution and Termination
eventually will come to an end. A partner may be in
ventures
All joint
need of funds, become a bankrupt, or die. The partners may encounter
basic disagreement as to the operation of the property. How the parties
meet these situations, and provide for some degree of continuity and
order in connection therewith, is the subject of this section.
1. Operating Under the UPA
Any change in the relation of the partners "caused by any partner
ceasing to be associated in the carrying on" of the business will cause a
dissolution of the partnership. °1 Section 31 of the UPA specifies the
causes of dissolution. Under this section, dissolution will occur, inter alia,
at the will of any partner pursuant to the agreement or in contravention
thereof, on the death of a partner, or on the bankruptcy of a partner.
This is consistent with the aggregate theory of partnership. Since the
partnership is an association of persons in theory and in the express terms
of section 31 of the UPA, no one specific association can exist if a partner ceases to be associated in the carrying on of the business. According
to the official Comment to this section:
The relation of partners is one of agency. The agency is such a personal one that
equity cannot enforce it even where the agreement provides that the partnership
shall continue for a definite time. The power of any partner to terminate the relation,
even though in doing so he breaks a contract, should, it is submitted, be recognized. 00
Thus, notwithstanding the language of the agreement, any partner can
force a dissolution of the partnership-subject, of course, to personal
liability if his action is a breach of the terms of the agreement. Upon dissolution, any partner who has "not wrongfully dissolved the partnership
or the legal representative of the last surviving partner, not bankrupt, has
the right to wind up the partnership affairs," unless otherwise agreed. 0 7
For cause, any partner, his legal representative or an assignee may obtain
winding up from the court. 80
As has been noted, 0 9 the UPA is a compromise between the entity and
304. Treas. Reg. § 1.704-1(c) (3) (i), example (3) (1956).
305. UP.A. § 29.
306. Id. § 31, Comment.
307. Id. § 37.
308. Id. The words "any person" have been interpreted not to include a partner expelled
for cause. See A. Bromberg, supra note 59, § 83A(b), at 475.
309. See part II B 3 supra.
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[Vol. 39
aggregate theories, and here that compromise shines in all its inconsistency. The statutory language just discussed reflects the aggregate theory,
but the entity aspects are not ignored. First, the partnership does not terminate upon dissolution, but continues until winding up.Y1 Second, where
dissolution is in contravention of the agreement, the non-defaulting partners may under certain circumstances continue the business.,, Third,
section 41, by implication, indicates that the business can be continued
in a variety of situations-in certain cases without even an assignment
of a deceased or retired partner's interest.81 2 Fourth, sections 17 and
18(g) of the UPA more than imply that admission of a new partner with
the consent of the existing partners may be accomplished without dissolution. This would seem consistent with the section 29 definition of dissolution, which refers only to a change in relation caused by a partner
"ceasing to be associated" with the partnership. And fifth, at least one
authority strongly supports as the better view the theory that "changes
in membership pursuant to agreement do not necessarily cause dissolution., 1 3
Without discussing in any great detail the metaphysics involved in
determining when dissolution occurs, what dissolution is, and how partnerships can arise, phoenix-like, from their own ashes, it should be fairly
clear that many institutional investors and developers wish to frame
their agreement so as to avoid these problems.1 4
2. The Language of the Agreement
All of what is said in the agreement is, of course, subject to the UPA
provisions on dissolution and winding up. The developer is not normally
apprehensive that the language of the agreement will not be adhered to
by the institution, not only because of the nature of institutional investors, but also because the institution or even its subsidiary would presumably be far from judgment proof. The institution also is not terribly
concerned about the failure of the developer to adhere to the language
of the agreement in this respect, since it presumably will have sufficient
assets to protect itself in any sale under a forced winding up of the
partnership.
The developer will normally wish to be able to transfer all or a portion
310.
311.
U.P.A. § 30.
Id. § 38(2)(b).
312.
See id.
§ 41(3).
313. See A. Bromberg, supra note 59, §§ 73, 78A.
314. Apparently, some institutional investors make no provision in their agreement for
termination of the partnership, but rely on general application of law. Their feeling is that
on termination of the partnership the partners will become tenants in common, and an
action for partition would lie. See part IV A supra.
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REAL ESTATE EQUITY INVESTMENTS
of his interest to third parties. The institution, while it might permit the
transfer of a portion of the developer's interest,3 15 is relying on the expertise of the developer and will normally insist that he retain a substantial economic interest in the partnership for a considerable period
of time. A compromise along these lines can normally be worked out.
The agreement also may provide that when the time is reached wherein
either or both parties can transfer all or a substantial portion of their
interests, the nontransferring party will have a right of first refusal. This
right protects it from managers or partners with whom it would prefer
not to deal. As a practical matter, however, except for the developer's
possible syndication of portions of his interest which, for economic and
other reasons, the institution may wish to restrict, sales of interests in
partnerships or partial interests in land are not easily consummated and,
if consummated, may be at a price somewhat lower than the selling partner's percentage interest in the partnership would warrant. Thus the
parties are more interested in the right to terminate the venture and sell
the entire partnership.
If the parties disagree as to major decisions, or if for some other
reason they wish the partnership ended, they may usually take advantage
of a buy-sell arrangement which is often found in the partnership agreement. Basically, one partner sets a price on the entire partnership or the
real estate, and the other partner has the option of either buying the first
partner's interest or selling his interest to the first partner at a pro rata
percentage of the price set by the first partner.3 16 The developer often
raises objection to this on the ground that in a tight money situation he
might be unable to raise the money, and thus would be forced to sell at
what might be too low a price. The solution is normally to provide a
reasonable period of time between exercise of the buy-sell and closing,
so that funds can be raised. While the buy-sell appears to be a simple
solution, its implementation may cause significant problems. For example,
valuation of partnership interests, with contingent obligations and existing contracts, as well as interests in real estate, is difficult; and the
315.
To provide some assurance that the formation of the joint venture (or any sub-
sequent sale by the developer of his interest therein) is not subject to registration or regulation under federal or state securities laws, the institutional investor may require an opinion
from its counsel as a condition of entering into the joint venture. It may also require an
opinion from the developer's counsel to the same effect, and a representation and warranty
from the developer that he has not and will not sell, offer for sale or solicit offers to
purchase, directly or indirectly, any portion of his interest in the joint venture to or from
any person or entity so as to require registration or qualification of such sale under federal
or state securities laws.
316. In a default situation, the defaulting partner is often considered the non-withdrawing partner, giving the option to the nondefaulting partners.
FORDHAM LAW REVIEW
[Vol. 39
hiatus between exercise of the option and closing can be the source of
innumerable problems." 7 Some joint venture agreements will provide,
in addition to the buy-sell, that either party may negotiate a sale of the
entire assets of the partnership to a third party, provided that the
other party is given a right of first refusal.
The developer often wishes his interest transferred to his heirs or
representatives upon his death or disability. The institution, however,
does not look forward to substituting for the expertise of the developers
the inexperience of a host of heirs. The agreement therefore often provides for an appraisal of the property on death or disability, with the
institution having the option of obtaining a hundred percent interest by
paying the partner's heirs or representatives the appraised value of the
deceased or disabled partner's interest; the invocation of the buy-sell as
against the estate, under which the estate would have the option of
buying the institution's interest or selling its interest to the institution;
or the transfer of the deceased partner's interest to his heirs or representatives, but only as limited partners with no control over the operation
of the property; or a combination of the foregoing.
Because of the loss of the expertise of the developer, the venture often
obtains key-man insurance on the developer's life. The institution must
be certain in several states that it does not attempt to designate the
insurance company or, if it is an insurance company, that it does not
require that it be designated as the insurer, for various reasons, possibly
including usury."'
When the developer becomes a bankrupt, the situation from the institution's standpoint is similar to the partner's death: i.e., the institution,
in view of the fact that the bankruptcy trustee and the institution would
probably have different objectives, might not consider the trustee a compatible partner. The solutions, however, are more limited, because the
buy-sell or limited partnership approaches might not be enforceable
against a trustee in bankruptcy. As successor to the bankrupt partner,
the trustee may rely on his rights under the Bankruptcy Act, which requires the nonbankrupt partners to "settle the partnership business as
expeditiously as its nature will permit and account for the interest of the
general partner or partners adjudged bankrupt, 8 10 or perhaps, under
317. During this hiatus, the "Huey, Louie and Dewey" clause becomes invaluable. See
part IV B 1 supra.
318. Care must be exercised, inter alia, with respect to state laws regulating unfair insurance practices, and possible breaches of the anti-trust laws. As to usury, see Equitable Life
Assurance Soc'y of the United States v. Scali, 38 Ill. 2d 544, 232 N.E.2d 712 (1967), which
held that such a requirement in a mortgage situation was not usurious.
319. Bankruptcy Act § 5(i), 11 U.S.C. § 23(i) (1964). This section also provides that
partnership property shall not be administered in bankruptcy when at least one of the
general partners is not bankrupt unless all nonbankrupt general partners consent.
1971]
REAL ESTATE EQUITY INVESTMENTS
UPA section 37, ask a court for a winding up for cause shown. The appraisal technique previously discussed might be considered both an
orderly and expeditious method of settling the partnership business and
accounting for the interest of the bankrupt partner. Thus, some agreements may provide that the nonbankrupt partner or partners may elect
an appraisal in lieu of winding up the partnership, even though appraisals
are difficult and appraisers are known to vary dramatically in their conclusions about the value of the same propertyYl Whatever provision is
inserted in the partnership agreement, it will be subject to a possible
attempt by the trustee to reject it if he believes it to be burdensome
to the estatef 21 In any such case, however, it would seem that the contract which could be rejected would be the partnership agreement and
not just a particular provision thereof, so that the trustee, as far as his
rights of rejection are concerned, would have to accept the partnership
agreement as written or abandon the partnership. 32
V. CONCLUSION
While institutional equity investments in real estate are new, while
structuring of the joint venture is difficult and complex, and while the
risks can be large, it now seems that such equity investments of one form
or another will become a significant factor in institutional portfolios.
However, while joint ventures by institutions are new, some legal relationships they create are traditional. Many problems that arise stem from
the fact that these legal relationships are employed perhaps in different
ways, in different combinations and under different circumstances than
they have been previously. All the consequences of this new employment
may not yet have been fully ascertained. This article has considered
many of the existing problems facing the institutional investor and the
present thinking with respect to solutions to those problems. It is expected
that over the years new problems will arise, and new solutions to existing
problems will become apparent.
Institutional investors have not been in the "joint venture" field long
enough to evaluate their profitability and success on the basis of any
320. Such a provision might specify that upon filing of a petition by or against a
partner, such partner shall automatically cease to be a member of the partnership and the
remaining partners shall then proceed to settle the partnership business and account for the
interest of the bankrupt partner. It might then be further provided that in settling the
partnership business the nonbankrupt partners could account for the bankrupt's share.
either by an appraisal and payment to the trustee, by a winding up of the partnership and
distribution of the assets, or by any other equitable and feasible means.
321. See Bankruptcy Act § 70(b), 11 US.C. 110(b) (1964). See also Creedon & Zinman,
(July 1971) (part 11).
Landlord's Bankruptcy: Laissez Les Lessees, 26 Bus. Law. 322. In re Italian Cook Oil Corp., 190 F.2d 994 (3d Cir. 1951).
FORDB'AM LAW REVIEW
more than scattered returns. It has become clear that "joint ventures"
in real estate are not simple transactions to negotiate or document. The
legal, printing and other costs of putting a joint venture together suggest
that it may not be feasible for small transactions. Furthermore, projections are not perfect, and the institution is known to be investing in a riskbearing situation. For example, the institution should know that in a
period of business recession or rapid inflation, it may well have to invest far
larger sums than were originally projected. While large institutions can
easily do this, smaller institutions may find themselves hard pressed to
expend large sums to honor commitments and bring joint ventures
through troubled times. This, together with the complexity of the transaction, might tempt one to quote Benjamin Franklin when he said: "Great
Estates may venture more; Little Boats should keep near shore. " "a
With the growing sophistication of both the developer and the institutional investor in this area, however, and the growing standardization of
philosophy and form, a kind of modus vivendi may soon be realized
which may herald the day when neither size of the venturer nor the
amount of money involved will act as a deterrent to the creation of institutional joint ventures in real estate.
323.
B. Franklin, The Sayings of Poor Richard 26 (T. Russel ed. 1926).